Chapter 2:
Cost Terminology and Cost
Behaviors
Cost Accounting:
Foundations and Evolutions, 8e
Kinney ● Raiborn
Learning Objectives
◼ Why are costs associated with a cost object?
◼ What assumptions do accountants make about cost
behavior, and why are such assumptions necessary?
◼ How are costs classified on financial statements, and why
are such classifications useful?
◼ How does the conversion process occur in manufacturing
and service companies?
◼ What are the product cost categories, and what items
comprise those categories?
◼ How and why does overhead need to be allocated to
products?
◼ How is cost of goods manufactured calculated and used in
preparing an income statement?
Cost
Monetary measure of resources given up to attain an objective (such as
acquiring a good or delivering a service)
Cost Categories
◼ Association with cost object
❑ Cost object is anything for which management
wants to collect or accumulate costs
◼ Reaction to changes in activity
◼ Classification on the financial statements
Association with a Cost Object
◼ Direct—traceable to a cost object
◼ Indirect—not conveniently or practically
traceable to a cost object
❑ Treated as overhead
❑ Allocated
Reaction to Changes in Activity
◼ Variable
◼ Fixed
◼ Mixed
◼ Step
Relevant Range—normal operating range
Cost Reaction to Changes in Activity
◼ Variable cost ◼ Fixed Cost
$
$
# of Units # of Units
Within the
relevant range
Cost Reaction to Changes in Activity
◼ Variable cost ◼ Fixed Cost
$ $
Total Total
# of Units # of Units
Unit $ Unit $
Within the
# of Units relevant range # of Units
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Total and Unit Cost Behavior
Total Cost Unit Cost
Varies in direct Remains constant
Variable
proportion to throughout the
Cost
changes in activity relevant range
Fixed Varies inversely
Remains constant
Cost with changes in
throughout
activity throughout
the relevant range
the relevant range
Cost Reaction to Changes in Activity
◼ Step Cost (fixed) ◼ Mixed Cost
variable
$ $
fixed
# of Units # of Units
Within the
relevant range
Determining Cost Behavior
◼ Cost Predictor ◼ Cost Driver
❑ Activity accompanied ❑ Activity that has a
by consistent, direct cause-effect
observable changes in relationship on cost
a cost item
❑ Predicts but may not ❑ Directly causes the
cause the cost to cost to change
change
Classification on the Financial
Statements
◼ Unexpired—balance sheet assets
◼ Expired—income statement expenses
◼ Product—inventoriable costs
❑ Prime—direct material and direct labor
❑ Conversion—direct labor and overhead
❑ Product costs are unexpired before sale
❑ Product costs are expired when sold
◼ Period—expensed in period incurred
Product Costs
◼ Product costs
❑ Direct material—Measurable part of a product
❑ Direct labor—Labor used to manufacture a
product or perform a service
❑ Overhead—Indirect production cost
◼ First appear on the balance sheet in
inventory accounts
◼ Transferred to the income statement when
product is sold
Period Costs
◼ Period costs
❑ Selling and administrative costs
❑ Distribution costs
◼ Cost to warehouse, transport, and/or deliver a product or
service
◼ Major impact on managerial decision making
◼ Appear on the income statement when
incurred
◼ Expensed when incurred
The Conversion Process
◼ Change inputs into outputs
The Conversion Process
Input Output
Purchase Product
raw materials or
or supplies Service
CONVERSION
Degrees of Conversion
Low Moderate High
Moderate
◼ Low ◼ High
❑ Department stores ❑ Manufacturing
❑ Gas stations ❑ Construction
❑ Jewelry stores ❑ Agriculture
❑ Travel agencies ❑ Architecture
◼ Moderate ❑ Auditing
❑ Mining
❑ Florists
❑ Printing
❑ Meat markets
❑ Restaurants
❑ Oil-change businesses
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a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Service Company
Input
Purchase
supplies
Significant amount of labor
Tangible or intangible output
Use supplies,
labor, overhead Output
to provide service
Sell to
customer
Retail Company
Input
Output
Purchase
Warehouse
products
and/or display
for resale
Purchase finished goods Sell to
Resell to customers customer
Manufacturer
Significant amount of labor and machinery
Tangible output
Input Output
Purchase Finished
raw materials product
and supplies
Production
Center Sell to
add labor and
overhead
customer
Cost Accumulation in a
Manufacturing Company
Materials
Inventory
Work in Process
Inventory
Finished Goods Cost of
Inventory Goods Sold
Income
Balance Sheet Statement
Product Cost—Direct
◼ Direct Material
❑ Conveniently and economically traced
to cost object
◼ Direct Labor
❑ To manufacture a product or perform a service
❑ Includes wages paid to direct labor employees,
production bonuses, payroll taxes
❑ May include holiday and vacation pay, insurance,
retirement benefits
Product Cost—Indirect
◼ Overhead—indirect production costs
❑ Fringe benefits, if cannot be easily traced to
product
❑ Overtime, if due to random scheduling
❑ Cost of quality
◼ Prevention costs
◼ Appraisal costs
◼ Failure costs
Product Cost Behavior
◼ Direct Material Variable
◼ Direct Labor Variable
◼ Overhead Variable, fixed, or mixed
Overhead Cost Allocation
Assign indirect costs to one or more
cost objects
◼ To determine full absorption cost (GAAP)
◼ To motivate management
◼ To compare alternative courses of action for
planning, controlling, and decision making
Allocation process should be
rational and systematic
Overhead Cost Allocation
Assign indirect costs to one or more cost objects
◼ To determine full absorption cost (GAAP)
◼ To motivate management
◼ To compare alternative courses of action for
planning, controlling, and decision making
Allocation process should be rational and
systematic
Allocating Overhead
Actual Cost System
◼ Product Cost Cost Used
◼ Direct Materials Actual
◼ Direct Labor Actual
◼ Overhead Actual
Allocating Overhead:
Actual Cost System
◼ The Actual Cost System is not timely
◼ All costs must be known before calculating
product cost
Allocating Overhead:
Actual vs. Normal
Product Cost Actual Cost Normal Cost
System System
Direct Materials Actual Actual
Direct Labor Actual Actual
Overhead Actual Predetermined
Overhead Rate
Predetermined Overhead Rate
◼ Allows overhead to be assigned during the
period
◼ Compensates for fluctuations
❑ that are not related to activity level
❑ in activity level that do not affect fixed overhead
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a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Flow of Product Costs
Raw Materials Inventory XXX
Accounts Payable XXX
Work in Process Inventory XXX
Raw Materials Inventory XXX
Work in Process Inventory XXX
Variable Overhead Control XXX
Fixed Overhead Control XXX
Salaries/Wages Payable XXX
Flow of Product Costs
Variable Overhead Control XXX
Fixed Overhead Control XXX
Utilities Payable XXX
Supplies Inventory XXX
Accumulated Depreciation–Equipment XXX
Other accounts XXX
Flow of Product Costs
Work in Process Inventory XXX
Variable Overhead Control XXX
Fixed Overhead Control XXX
Finished Goods Inventory XXX
Work in Process Inventory XXX
Flow of Product Costs
Accounts Receivable XXX
Matches
Sales
revenues and
XXX
expenses on
the income
Cost of Goods Sold XXX
statement
Finished Goods Inventory
XXX
Statement of Cost of Goods
Manufactured—Raw Materials
Used
◼ Beginning balance $ 73,000
◼ Purchases of materials 280,000
◼ Raw materials available $353,000
◼ Ending balance <69,000>
◼ Total raw materials used $284,000
To Statement of Cost of Goods Manufactured
Statement of Cost of Goods
Manufactured
◼ Beginning work in process $145,000
❑ Raw materials used $284,000
❑ Direct labor 436,000
❑ Variable overhead 115,200
❑ Fixed overhead 98,880
◼ Current period manufacturing costs 934,080
◼ Total costs to account for $1,079,080
◼ Ending work in process <20,880>
Cost of goods manufactured $1,058,200
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a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Schedule of Cost of Goods Sold
◼ Beginning Finished Goods $ 87,400
◼ Cost of Goods Manufactured 1,058,200
◼ Cost of Goods Available for Sale $1,145,600
◼ Ending Finished Goods <91,600>
◼ Cost of Goods Sold $1,054,000
From Schedule of Cost of Goods Manufactured
Income Statement
◼ Revenue XXXX
◼ Cost of Goods Sold <1,054,000>
◼ Gross Profit XXXX
◼ Operating Expenses <XXXX>
◼ Operating Income XXXX
From Schedule of Cost of Goods Sold
Questions
◼ What is the difference between a fixed and
variable cost?
◼ What are the three components of product
cost?
◼ What are the three inventory accounts for a
manufacturing company?
Ethical Issues
◼ Expired costs—not on the balance sheet
◼ Period costs—not inventory
◼ Product costs—not selling or administrative
costs
◼ Direct labor—not overstated
◼ Ending inventory—not overstated
