Managerial Accounting and

Costs Terms, Concepts and

Classifications
Chapter Two
Part 1
• This chapter explains that in managerial accounting , the term
Cost is used in many different ways. The reason is that there
are many types of costs and these costs are classified
differently according to the immediate needs of management.
What do we mean by cost
• Cost – sacrificed resource to achieve a specific objective
• Cost is usually measured as the monetary amount that must be
paid to acquire goods or services.
• When you think of cost you should think in the light of finding
the cost of a particular thing which is called cost object

 Cost object – the thing that we need to know how much cost /
unit (product, service, project, customer, activity, department)
 ❷ Cost Concepts
Notice: cost objects include anything we
want to measure its cost as products,
services, customers, departments …. etc.

We can classify the cost according 6 classifications:

❶ ❷ ❸
Time of measurement Relation with cost object For reporting purpose
① Budgeted ① Direct ①Inventoriable(product)
② Actual ② Indirect ② Period

❹ ❺ ❻
Functional classification Cost behaviour Decision Making
① Manufacturing ① Fixed ① Relevant
② Nonmanufacturing ② Variable ② Irrelevant
 Cost Classifications
• 1-General (Functional) Classification:
• Manufacturing Costs
• D. Materials
• D. Labor
• Overhead

Non-manufacturing
• Selling Expenses
• Administrative Expenses
Classifications of Manufacturing Costs

Direct Direct Manufacturing

Materials Labor Overhead

The Product
5
 Direct Materials

Raw materials that become an integral part of the

product and that can be conveniently traced directly
to it.

Example: A wood used in a chair

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 Direct Labor
That portion of labor costs that can be easily traced to individual units of

product.

Direct labor is sometimes referred to as “touch labor,” since it consists of

the costs of workers who “touch” the product as it is being made.

Example: Wages paid to carpenters

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 Manufacturing Overhead

Manufacturing costs that cannot be easily

traced directly to specific units produced.
Examples: Indirect materials and indirect labor

Materials used to support Wages paid to employees

the production process. who are not directly
involved in production work.
Examples: glue, nails, Examples: maintenance
lubricants and cleaning workers, and security guards.
supplies used in the chair
assembly plant.
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 Classifications of Costs

Manufacturing costs are often

classified as follows:
Direct Direct Manufacturing
Material Labor Overhead

Prime Conversion
Cost Cost
1 - 2 The following costs were incurred in August:
Direct materials $ 37,000
Direct labors $ 14,000
Manufacturing overhead $ 38,000
Selling cost $ 10,000
Administrative cost $ 28,000
1 - Conversion costs during the month totaled:
2 - Prime costs during the month totaled:
 Non-manufacturing Costs

Marketing or Administrative
Selling Cost Cost

Costs necessary to get All executive,

the order and deliver the organizational, and
product. clerical costs.
 Example 1: Classifying Manufacturing Costs
• Your Boat, Inc., assembles custom sailboats from components supplied
by various manufacturers. Below are listed some of the costs that are
incurred at the company.
• 1. The wages of employees who build the sailboats.
• 2. The cost of advertising in the local newspapers.
• 3. The cost of an aluminum mast installed in a sailboat.
• 4. The wages of the assembly shop’s supervisor.
• 5. Rent on the boathouse.
• 6. The wages of the company’s bookkeeper.
• 7. Sales commissions paid to the company’s salespeople.
• 8. Depreciation on power tools.
• Required: For each cost, indicate whether it would most likely be
classified as direct labor, direct materials, manufacturing overhead,
selling, or administrative cost.
 solution
1. The wages of employees who build the sailboats: direct labor cost.
• 2. The cost of advertising in the local newspapers: marketing and selling
cost.
• 3. The cost of an aluminum mast installed in a sailboat: direct materials
cost.
• 4. The wages of the assembly shop’s supervisor: manufacturing overhead
cost.
• 5. Rent on the boathouse: a combination of manufacturing overhead,
administrative, and marketing and selling cost. The rent would most likely
be prorated on the basis of the amount of space occupied by
manufacturing, administrative, and marketing operations.
• 6. The wages of the company’s bookkeeper: administrative cost.
• 7. Sales commissions paid to the company’s salespeople: marketing and
selling cost.
• 8. Depreciation on power tools: manufacturing overhead cost.
 2 - Cost classification for Financial Reporting
For financial reporting purposes costs are classified into
Product (inventoriable)costs and Period costs

Product costs include direct Period costs include all

materials, direct labor, and marketing or selling costs
manufacturing overhead. and administrative costs.
(manufacturing) (Non-manufacturing)
Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
 example
• the following listing of cost item incurred during February 2019
for Alex Manufacturing:
• a-what is the total amount of product cost ?
• b-what is the total amount of period cost ?

Sales salaries $30,000 Property taxes factory $5,000

Indirect labor cost $20,000 Direct materials cost $200,000

Depreciation of factory equipment $25,000 Labor cost for machine operators 70,000
Advertising cost $15,000 Factory utilities $10,000

Warehouse rent $12,000 Administrative equipment depreciation

5,000
 Quick Check ✓
Which of the following costs would be
considered a period rather than a product cost in
a manufacturing company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production facility.
E. Sales commissions.
 Quick Check ✓
Which of the following costs would be
considered a period rather than a product cost in
a manufacturing company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.
Comparing Merchandising and Manufacturing Activities

Merchandisers . . . Manufacturers . . .
 Buy finished goods.  Buy raw materials.
 Sell finished goods.  Produce and sell finished
goods.

MegaLoMart
 Balance Sheet

Merchandiser Manufacturer
Current assets Current Assets
◆ Cash Cash
◆ Receivables Receivables
◆ Prepaid Expenses Prepaid Expenses
◆ Merchandise Inventory Inventories
Raw Materials
Work in Process
Finished Goods
 Balance Sheet

Merchandiser Manufacturer
Current assets Current Assets
◆ Cash Cash
◆ Receivables Receivables
Materials waiting to be
◆ Prepaid Expenses Prepaid Expenses
processed .
◆ Merchandise Inventory Inventories
Partially complete Raw Materials
products – some material,
labor, or overhead has Work in Process
been added. Finished Goods

Completed products
awaiting sale.
 3-cost classification for assigning costs to cost objects
➢ For assigning costs to cost objects, in other words to determine
how much cost/unit, costs are classified according to its relation
to a unit of cost object (ex. a unit of production).

➢ According to relation with a unit of production, manufacturing

costs are classified into Direct costs and Indirect costs

Direct costs Indirect costs

• Costs that can be • Costs that cannot be easily
easily and conveniently and conveniently traced to
traced to a unit of product a unit of product or other
or other cost object. cost object.
• Examples: direct material • Example: manufacturing
and direct labor overhead
 4- Time of measurement
Budgeted cost When do
Before after
Forecasted, Actual cost
you
measure The cost incurred
estimated, or
cost, before about past action.
predicted cost or after the Also called a
about the future action? historical cost.
action. Yes No
 5 - Cost Classifications for Decision Making
• Every decision involves choosing from among at least two
alternatives. Only those costs and benefits that differ between
alternatives are relevant in making the selection. This concept is
explored in greater detail in the chapter on relevant costs.

• Costs are classified for Decision Making into three types:

Differential Costs Opportunity Costs
Sunk Costs

❖ Differential Costs and Opportunity Costs should be the focus

of decision-making. They are the only relevant costs.

❖ All other costs that Do Not differ among competing alternatives

and sunk costs should be ignored.
 2-24

Differential Cost and Revenue

Costs and revenues that differ among

alternatives.
Example: You have a job paying $1,500 per month in your
hometown. You have a job offer in another city that pays $2,000
per month. The commuting cost to the city is $300 per month.

Differential revenue is: Differential cost is:

$2,000 – $1,500 = $500 $300
 2-25

Opportunity Cost
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
$15,000 per year.

Your Opportunity Cost of attending

college for one year is $15,000.
 2-26

Sunk Costs

Sunk costs have already been incurred

and cannot be changed now or in the
future. These costs should be ignored
when making decisions.

Example: Suppose you had purchased gold for

$400 an ounce, but now it is selling for $250 an
ounce. Should you wait for the gold to reach $400 an
ounce before selling it? You may say, “Yes” even
though the $400 purchase is a sunk costs.
 2-27

Quick Check ✓
Suppose you are trying to decide whether to
drive or take the train to Portland to attend a
concert. You have ample cash to do either, but
you don’t want to waste money needlessly. Is
the cost of the train ticket relevant in this
decision? In other words, should the cost of the
train ticket affect the decision of whether you
drive or take the train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.
 2-28

Quick Check ✓
Suppose you are trying to decide whether to
drive or take the train to Portland to attend a
concert. You have ample cash to do either, but
you don’t want to waste money needlessly. Is
the cost of the train ticket relevant in this
decision? In other words, should the cost of the
train ticket affect the decision of whether you
drive or take the train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.
 2-29

Quick Check ✓
Suppose you are trying to decide whether to
drive or take the train to Portland to attend a
concert. You have ample cash to do either, but
you don’t want to waste money needlessly. Is
the annual cost of licensing your car relevant in
this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
 2-30

Quick Check ✓
Suppose you are trying to decide whether to
drive or take the train to Portland to attend a
concert. You have ample cash to do either, but
you don’t want to waste money needlessly. Is
the annual cost of licensing your car relevant in
this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
 2-31

Quick Check ✓
Suppose that your car could be sold now for
$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.
 2-32

Quick Check ✓
Suppose that your car could be sold now for
$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.
2-33