1.
Chapter 1: Introduction to Cost Accounting and Cost Concepts
Lecture Notes
● Definition of Cost Accounting: The process of collecting, analyzing, and
reporting financial and non-financial information related to the costs of
acquiring or using resources in an organization. It's an internal tool used
by management for planning, controlling, and decision-making.
● Cost vs. Expense:
○ Cost: A sacrifice of resources to achieve a specific objective. It can
be an asset (e.g., inventory) or an expense.
○ Expense: A cost that has been consumed to generate revenue in a
given period (e.g., Cost of Goods Sold).
● Cost Classifications: Costs are classified for different purposes.
○ For Financial Reporting (Product vs. Period Costs):
■ Product Costs: All costs incurred to manufacture a product.
These costs "attach" to the product and are expensed only
when the product is sold (as Cost of Goods Sold). Includes:
■ Direct Materials (DM): Raw materials that can be
easily traced to the finished product.
■ Direct Labor (DL): The cost of labor that can be
physically and directly traced to the creation of the
product.
■ Manufacturing Overhead (MOH): All other
manufacturing costs that are not DM or DL. Includes
indirect materials, indirect labor, factory utilities, and
depreciation on factory equipment.
■ Period Costs: All costs that are not product costs. They are
expensed in the period in which they are incurred. These are
also known as operating expenses. Includes:
■ Selling and Administrative (S&A) Expenses: Costs
related to selling the product or running the general
business operations (e.g., sales commissions, office
rent).
○ For Decision-Making (Relevant Costs):
■ Differential Costs: A future cost that differs among the
alternatives.
■ Sunk Costs: A cost that has already been incurred and
cannot be changed. Sunk costs are irrelevant to future
decisions.
■ Opportunity Cost: The potential benefit that is given up
when one alternative is selected over another.
○ For Cost Behavior (How costs react to changes in activity
levels):
■ Variable Costs: Total cost changes in direct proportion to
changes in activity level. The cost per unit remains constant.
(e.g., Direct Materials).
■ Fixed Costs: Total cost remains constant within the relevant
range, regardless of changes in activity level. The cost per
unit decreases as activity increases. (e.g., Rent).
■ Mixed Costs: Contains both a variable and a fixed
component (e.g., a phone bill with a fixed monthly fee plus a
variable charge per minute).
● The Three Inventory Accounts:
○ Raw Materials Inventory: Materials waiting to be used in
production.
○ Work-in-Process (WIP) Inventory: Partially completed goods.
Costs are added from Direct Materials, Direct Labor, and
Manufacturing Overhead.
○ Finished Goods (FG) Inventory: Completed goods ready for sale.
● Flow of Costs:
○ Direct Materials, Direct Labor, and Manufacturing Overhead costs
flow into WIP Inventory.
○ When products are completed, their costs are transferred from
WIP Inventory to Finished Goods Inventory.
○ When products are sold, their costs are transferred from Finished
Goods Inventory to Cost of Goods Sold (COGS) on the Income
Statement.
Summary (Chapter 1)
Cost accounting is an internal management tool for planning and control. The
key distinction is between product costs (DM, DL, MOH) which "stick" to
inventory until sold and period costs (S&A) which are expensed immediately.
This classification is crucial for external financial reporting. For internal
decision-making, costs are classified based on their relevance (e.g., identifying
differential costs and ignoring sunk costs). Another important classification is
by cost behavior, which distinguishes between variable costs (change in total
with activity), fixed costs (constant in total), and mixed costs. Finally,
manufacturing costs flow through three inventory accounts (Raw Materials,
WIP, and Finished Goods) before becoming Cost of Goods Sold.