Basic Cost Management Concept

Chapter 2
Basic Cost
Management Concepts
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McGraw-Hill/Irwin McGraw-Hill Education.
Learning Objective 2-1 – Explain what is meant by the word
cost.
McGraw-Hill Education.
Process of Management
Strategy Planning
Formulation
Managers need cost information to

perform each of these functions.
Control Directing
Decision
Making
What Do We Mean By a Cost?
A cost
is the measure of
resources given
up to achieve a
particular purpose.
Learning Objective 2-2 – Distinguish among product costs,
period costs, and expenses.
Product Costs, Period Costs, and
Expenses
Product costs are costs assigned to inventory, to
goods that are either purchased or manufactured
for resale. Another term for product cost is
inventoriable cost.
Period costs are costs that are expensed during

the time period in which they are incurred.
Expenses are the consumption of assets for the

purpose of generating revenue.
Learning Objective 2-3 – Describe the role of costs in
published financial statements.
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Cost Classifications on Financial
Statements – Income Statement
Product Costs Period Costs
Cost of goods sold Operating expenses
Statements – Balance Sheet (1 of 4)
Merchandiser Manufacturer
Current Assets Current Assets
Cash  Cash
Receivables  Receivables
Prepaid Expenses  Prepaid Expenses
Merchandise Inventory  Inventories
• Raw Materials
• Work in Process
• Finished Goods
Cash  Cash materials
Those
Receivables  waiting to be
Receivables
Prepaid Expenses processed.
Merchandise Inventory  Inventories
• Raw Materials
• Work in Process
• Finished Goods
Partially completed
Cash
products
 Cash – material to
which some labor
 Receivables
Receivables and/or overhead has
 Prepaid Expenses
Prepaid Expenses been added.
 Inventories
Merchandise Inventory
• Raw Materials
• Work in Process
• Finished Goods
Cash  Cash
 Receivables
Receivables Completed products
Prepaid Expenses awaiting
 Prepaid sale.
Expenses
 Inventories
Merchandise Inventory
• Raw Materials
• Work in Process
• Finished Goods
Learning Objective 2-4 – List and describe four types of
manufacturing processes.
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Types of Production Processes
Learning Objective 2-5 – Give examples of three types of
manufacturing costs.
Manufacturing Costs
Direct Direct Manufacturing

Material Labor Overhead
The
Product
Direct Material
Cost of raw material that is used to

make, and can be conveniently
traced, to the finished product.
Example:
Steel used to
manufacture
the automobile.
Direct Labor
Cost of salaries, wages, and fringe

benefits for personnel who work
directly on manufactured products.
Example:
Wages paid to an
automobile assembly
worker.
Manufacturing Overhead (1 of 3)
All other manufacturing costs
Indirect Indirect Other
Material Labor Costs
Materials used to support

the production process.
Examples: lubricants and
cleaning supplies used in an
automobile assembly plant.
Cost of personnel who

do not work directly on
the product. Examples:
maintenance workers,
janitors, and security
guards.
Examples: depreciation
on plant and equipment,
property taxes,
insurance, utilities,
overtime premium, and
unavoidable idle time.
Classifications of Costs in
Manufacturing Companies
Manufacturing costs are often combined as follows:
Direct Direct Manufacturing

Material Labor Overhead
Prime Conversion
Cost Cost
Manufacturing Cost Flows
Learning Objective 2-6 – Prepare a schedule of cost of goods
manufactured, a schedule of cost of goods sold, and an
income statement for a manufacturer.
Schedule of Cost of Goods
Manufactured (1 of 4)
Comet Computer Corporation
Schedule of Cost of Goods Manufactured
Raw material used $ 134,980

Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs $ 414,980
Add: Work-in-process inventory, January 1 120
Subtotal $ 415,100
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured $ 415,000
Schedule of Cost of Goods Manufactured (2 of 4)
Computation of Cost of Raw Material Used
Raw-material inventory, January 1 $ 6,000
Add: Purchases of raw materials 134,000
Raw material available for use 140,000
Deduct: Raw material inventory, December 31 5,020


Direct labor 50,000
Subtotal $ 415,100
Include all direct labor
costs incurred during the
Cometcurrent period.
Computer Corporation

Direct labor 50,000
Subtotal $ 415,100
Computation of Total Manufacturing Overhead
Indirect material $ 10,000

Indirect labor 40,000
Depreciation on factory 90,000
Depreciation on equipment 70,000
Utilities 15,000
Insurance Comet Computer
5,000 Corporation
Total manufacturing overheadSchedule of$Cost
230,000
of Goods Manufactured

Direct labor 50,000
Subtotal $ 415,100
Schedule of Cost of Goods
Manufactured - WIP
Beginning work-in-
process inventory is
carried over from the
prior period.

Direct labor 50,000
Ending work-in-process
inventory contains the
Add: Work-in-process cost ofJanuary 1
inventory, 120
unfinished
Subtotal goods, and is $ 415,100
reported in the current inventory,
Deduct: Work-in-process assets December 31 100
section of themanufactured
Cost of goods balance sheet. $ 415,000
Income Statement for a Manufacturer

Income Statement
For the Year Ended December 31, 20X2
Sales revenue $ 700,000
Less: Cost of goods sold 415,010
Gross margin $ 284,990
Selling and administrative expenses 174,490
Income before taxes $ 110,500
Income tax expense 30,000
Net income $ 80,500
Schedule of Cost of Goods Sold
Schedule of Cost of Goods Sold
Finished-goods inventory, Jan. 1 $ 200

Add: Cost of goods manufactured 415,000
Cost of goods available for sale 415,200
Deduct Finished-goods inventory, Dec. 31 190
Income Statement
Cost of goods sold $ 415,010
Sales revenue $ 700,000
Less: Cost of goods sold 415,010
Gross margin $ 284,990
Selling and administrative expenses 174,490
Income before taxes $ 110,500
Income tax expense 30,000
Net income $ 80,500
Learning Objective 2-7 – Understand the importance of
identifying an organization's cost drivers.
Cost Drivers
Activities that cause costs to be incurred are called COST DRIVERS:
Learning Objective 2-8 – Describe the behavior of variable
and fixed costs, in total and on a per-unit basis.
Cost Classifications
Cost behavior means how a cost will react to

changes in the level of business activity.
Total variable costs change when activity
changes.
Total fixed costs remain unchanged when
activity changes.
Total Variable Cost Example
Your total
monthly bill is
Total Amazon Prime Bill
based on how
many movies
you watch.
Prime (for-fee) Movies Watched
Variable Cost Per Unit Example
The cost per movie

watched is
Per Movie Charge

constant. For
example, @ $4.00
per movie.
Movies Watched
Total Fixed Cost Example
Your monthly subscription cost does not change
when you watch movies on streaming services
such as Netflix that charge a flat monthly fee.
Monthly Netflix
Charge
Number of Netflix Movies Watched
Graph of Unit Fixed Cost
The average cost per movie decreases as more Netflix
movies are watched.
Monthly Subscription per
Movie Watched
Number of Movies Watched

Cost Classifications - Summary
Cost Management Systems
Objectives
Objectives

Measure
Measure thethe cost
cost of
of resources
resources consumed.
consumed.

Identify
Identify and
and eliminate
eliminate non–value-added
non–value-added costs.
costs.

Determine
Determine efficiency
efficiency and
and effectiveness
effectiveness of of
major
major activities.
activities.

Identify
Identify and
and evaluate
evaluate new
new activities
activities that
that can
can
improve
improve performance.
performance.
Learning Objective 2-9 – Distinguish among direct, indirect,
controllable, and uncontrollable costs.
Direct and Indirect Costs
Direct costs Indirect costs

 Costs that can be easily  Costs that must be
and conveniently traced to allocated in order to be
a product or department. assigned to a product or
 Can easily assigned to department.
 Example: cost of paint in  Example: cost of national
the paint department of an advertising for an airline is
automobile assembly indirect to a particular
plant. flight.
Controllable and Uncontrollable Costs
A cost that can be significantly influenced by a manager is a
controllable cost.
Learning Objective 2-10 – Define and give examples of an
opportunity cost, an out-of-pocket cost, a sunk cost, a
differential cost, a marginal cost, and an average cost.
2-45
Opportunity Costs
Example: If you were not attending college,

you could be earning $30,000 per year. Your
opportunity cost of attending college for one
year is $30,000.
Out-of-Pocket Costs
Those costs that require the payment of

cash or other assets as a result of its
incurrence.
These costs should be considered when
making decisions.
Sunk Costs
All costs incurred in the past that cannot be

changed by any decision made now or in the future
are sunk costs.
Sunk costs should NOT be considered in decisions.
Example: You bought an automobile that cost
$22,000 two years ago. The $22,000 cost is sunk
because whether you drive it, park it, trade it, or sell
it, you cannot change the $22,000 cost.
Differential Costs
Costs that differ between alternatives.
Example: You can earn $1,500 per month in your

hometown or $2,000 per month in a nearby city.
Your commuting costs are $50 per month in your
hometown and $300 per month to the city.
What is your differential cost?

$300 - $50 = $250
Marginal Costs and Average Costs
The total cost to

The extra cost
produce a quantity
incurred to produce
divided by the
one additional unit.
quantity produced.
Marginal and average costs are

largely a function of cost behavior
– variable and fixed costs.
Costs and Benefits of Information
Costs Benefits
More information does not mean more

benefits if information overload results.
End of Chapter 2

Basic Cost Management Concept

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Chapter 2

Managers need cost information to

Period costs are costs that are expensed during

Expenses are the consumption of assets for the

Product Costs Period Costs

Cost of goods sold Operating expenses

Direct Direct Manufacturing

Cost of raw material that is used to

Cost of salaries, wages, and fringe

Materials used to support

Cost of personnel who

Direct Direct Manufacturing

Raw material used $ 134,980

Comet Computer Corporation

Raw material used $ 134,980

Raw material used $ 134,980

Indirect material $ 10,000

Raw material used $ 134,980

Raw material used $ 134,980

Comet Computer Corporation

Finished-goods inventory, Jan. 1 $ 200

Cost behavior means how a cost will react to

Prime (for-fee) Movies Watched

The cost per movie

Per Movie Charge

Number of Netflix Movies Watched

Number of Movies Watched

Direct costs Indirect costs

Example: If you were not attending college,

Those costs that require the payment of

All costs incurred in the past that cannot be

Costs that differ between alternatives.

Example: You can earn $1,500 per month in your

What is your differential cost?

The total cost to

Marginal and average costs are

More information does not mean more

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