Chapter

Chapter 2 2
An introduction to cost
terms and purposes

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 Outline
Different costs
• Direct/indirect costs (+ cost objects) - Assigning costs to cost objects

• Manufacturing/non-manufacturing costs - Accounting for costs in manufacturing

companies

• Inventories Product/period costs - Preparing financial statements

• Cost of goods sold/manufactured (COGS/COGM)

• Fixed/variable costs - Predicting cost behavior in response to changes in activity

• Marginal costs, prime costs and conversion costs

• Differential costs, sunk costs, and opportunity costs – Costs for decision making

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 Three types of companies, their
operations and inventories
• Service

• Merchandisers

• Manufacturers

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 Service Companies
• Provide a service only
• No inventory
• Examples
– Advertising agencies
– Banks
– Law firms
– Insurance companies

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 Merchandisers
• Resell products purchased from suppliers
• One inventory account (type of)
• Examples
– Walmart
– Best Buy
– [Link]
• Retailers vs. Wholesalers – same type of
inventory account

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 Manufacturers
• Use labor and other inputs to convert raw
materials into finished products

• Examples
– Procter & Gamble
– General Mills
– Dell Computer

• Three inventory accounts

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 Manufacturers
• Three inventory accounts

– Raw materials

– Work in process

– Finished goods

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Comparison balance sheets
Merchandiser Manufacturer
Current assets Current Assets
– Cash – Cash
– Receivables – Receivables
– Prepaid expenses – Prepaid Expenses
– Merchandise inventory – Inventories
Raw Materials
Work in Process (WIP)
Finished Goods

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 Comparison balance sheets
• Merchandiser Manufacturer
• Current assets Current Assets
– Cash - Cash
– Receivables  Receivables
Materials waiting to
– Prepaid expenses be processed.
 Prepaid Expenses
– Merchandise inventory
Partially complete - Inventories
products – some Raw Materials
material, labor, or Work in Process
overhead has been Finished Goods
added.
Completed products
awaiting sale.
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Direct and indirect costs

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 Cost object
A cost object is anything for which managers want a separate
measurement of cost, such as:
• Individual products (a specific, custom-ordered Prius)
• Different models (the Prius, Rav4, and Corolla)
• Alternative marketing strategies (sales through dealers versus built-to-
order Web sales)
• Geographic segments of the business (United States, Europe, Japan)
• Departments (human resources, R&D, legal)

A direct cost is a cost that can be traced directly to a cost object; for
example, a steering wheel used in the production of a car would be a direct
cost.

An indirect cost is a cost that cannot be directly traced to the cost object;
for example, the cost of lubricants used in the manufacture of a car. Another
example would be a plant manager’s wages. These wages would not be
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 Direct and indirect costs
• Direct costs can be specifically and exclusively identified
with a given cost object.
Examples: direct material and direct labour

• Indirect costs cannot be specifically and exclusively identified

with a given cost object.
Example: manufacturing overhead

• Direct costs, are assigned to cost objects on the basis of

cost tracing.

• Indirect costs, also called overhead costs, are assigned to

cost objects on the basis of cost allocations.
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 Direct and indirect costs
between departments
• Direct costs (the costs have been traced directly
to these departments):
Maintenance department €30,000
Personnel department (“HR”)
€24,600 Assembly department
€70,000 Finishing department
€50,000
• Assume that Maintenance department costs
are allocated equally among the production
departments.
• How much is allocated to each department?
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 Direct and indirect costs
between departments (Continued)
Maintenance
€30,000

Assembly Finishing
direct costs direct costs
€70,000 €50,000
€15,000 €15,000
Allocated
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 Direct and indirect costs
(Continued)
• Several factors affect the classification of a cost
as direct or indirect:
– The materiality (importance) of the cost in
question
– Available information-gathering technology
– Design of operations
• The direct/indirect classification depends
on the choice of the cost object.

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Example Medina Kohl’s
Junior Department

A Indirect
B Direct
C Indirect
D Indirect
E Indirect
F Direct
G Direct
H Direct
I Indirect
J Indirect
K Indirect

L Indirect

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 Example Medina Kohl
Cost incurred Direct or indirect
Depreciation of the building Indirect
Cost of costume jewelry on the mannequins in
the Juniors Department Direct
Cost of bags used to package customer
purchases at the main registers for the store Indirect
The Medina Kohl’s store manager’s salary Indirect
Cost of the security staff at the Medina store Indirect
Manager of Juniors Department Direct
Juniors Department sales clerks Direct
Cost of Juniors clothing Direct
Cost of hangers used to display the clothing in
the store Indirect
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 Example Medina Kohl (cont.)
Cost incurred Direct or indirect
Electricity for the building Indirect
Cost of radio advertising for the store Indirect
Juniors clothing buyers’ salaries (these
buyers buy for all of the Juniors Departments
of Kohl’s stores) Indirect

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Manufacturing Costs

Manufacturing consists of activities and processes that

convert raw materials into finished goods.

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 Categories of Manufacturing
and Non-Manufacturing Costs
Traditional cost systems accumulate
product costs as follows:

Direct materials xxx

Direct labour xxx
Manufacturing overhead xxx
Total manufacturing cost xxx
Direct non-manufacturing costs xxx
Non-manufacturing overheads xxx
Total cost xxx
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Manufacturing Costs

Direct Materials
Raw Materials
Basic materials and parts used in
manufacturing process.

Direct Materials
Raw materials that can be physically and directly associated
with the finished product during the manufacturing process.

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Manufacturing Costs

Indirect Materials
1. Not physically part of the finished product or

2. they are an impractical to trace to the finished

product because their physical association with the
finished product is too small in terms of cost.

Considered part of manufacturing overhead.

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 Manufacturing Costs

Direct Labor
Work of factory employees that can be
physically and directly associated with
converting raw materials into finished
goods.

Indirect Labor
Work of factory employees that has no physical association with the
finished product or for which it is impractical to trace costs to the
goods produced. Considered part of manufacturing overhead.

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Manufacturing Costs
Manufacturing Overhead also called
Indirect manufacturing costs
 Costs that are indirectly associated with manufacturing
the finished product.
 Includes all manufacturing costs except direct materials
and direct labor.
 Also called factory overhead, indirect manufacturing
costs, or burden.

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 Manufacturing Overhead
• Manufacturing costs that are not traced
directly to specific units produced.
Examples:
Examples: Indirect
Indirect labor
labor and
and indirect
indirect materials
materials

Wages paid to employees Materials used to support

who are not directly the production process.
involved in production
work. Examples: lubricants and
Examples: maintenance cleaning supplies used in the
workers, janitors and automobile assembly plant.
security guards.

Other
Other examples:
examples: Machine
Machine costs
costs and
and costs
costs related
related to
to the
the
factory
factory
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 Classification of Costs into
Direct/indirect AND Manufact/non-manufacturing
Exercise
PC Works - A computer manufacturer Cost object: The product
[Link] cost of a hard-drive installed in a computer
[Link] cost of advertising in the Puget Sound Computer User
newspaper
[Link] wages of employees who assemble computers from
components
[Link] commissions paid to the company’s salespeople
[Link] wages of the assembly shop’s supervisor
[Link] wages of the company’s accountant
[Link] on equipment used to test assembled
computers before release to customers
[Link] paid for the factory in the industrial park
[Link] paid the building used by the administration in the
industrial park
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Exercise
Solution
PC Works - A computer manufacturer Cost object: The product
[Link] cost of a hard-drive installed in a computer
[Link] cost of advertising in the Puget Sound Computer User newspaper
[Link] wages of employees who assemble computers from components
[Link] commissions paid to the company’s salespeople
[Link] wages of the assembly shop’s supervisor
[Link] wages of the company’s accountant
[Link] on equipment used to test assembled computers before release to customers
[Link] paid for the factory in the industrial park
[Link] paid the building used by the administration in the industrial park

PC Works - A computer manufacturer Cost object: The product

[Link] cost Manufacturing
[Link] cost Non-manufacturing
[Link] cost Manufacturing
[Link] cost Non-manufacturing
[Link] cost Manufacturing
[Link] cost Non-manufacturing
[Link] cost Non-manufacturing (if we do not see the last QC as part of the
manufacturing process)
[Link] cost Manufacturing (if used for production)
[Link] cost Non-manufacturing
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Costs for inventories

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 A reminder from your previous
course in Financial Accounting
Capitalised costs
• Capitalised costs are all costs of a product
that are regarded as an asset when 1) they
are incurred and then become 2) cost of
goods sold when the product is sold.
• For manufacturing-sector companies, all
manufacturing costs are capitalised costs.

Check out this short video about Billy Bobs Restaurant:

[Link]

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 Two definitions of product costs
• Total costs: used internally only (e.g. pricing
decisions)
• Inventoriable product costs: used for external
reporting (for inventory valuation)
PLEASE NOTE BELOW – A number of different
names for the same thing

Costs which are first recorded in Cost which are expenses in

inventories the income statement
Capitalized costs Revenue costs
Manufacturing costs Non-manufacturing costs
Inventorieable Costs
Product Costs
Stock Costs Period
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Product Costs (aka Capitalized costs
Manufacturing costs, Inventorieable Costs, Stock Costs)

Product costs includes all the costs that are

involved in acquiring or making a product.

Product costs “attach” to a unit of product as it is

purchased or manufactured, and they stay attached
to each unit of product as long as it remains in
inventory awaiting sale.

Later when the product is sold, the product cost

will represent COGS in the Income Statement.
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Stock/Product Costs Versus Period Costs

Stock/Product costs Period costs are not

include direct included in product
materials, direct costs. They are
labour, and expensed on the
manufacturing income statement.
overhead.
Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
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 Stock/Product Versus Period Costs

Inventoriable cost a.k.a. Stock a.k.a. Product Costs

 Direct materials
  Direct labor
Components:
 Manufacturing overhead

 Costs that are an integral part of producing the product.

 Recorded in “inventory” account. I.e. they are “capitalized”.
 Not an expense (COGS) until the goods are sold.

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Stock/Product Versus Period Costs

Period Costs
 Charged to expense as incurred.
 Non-manufacturing costs.
 Includes all selling and administrative expenses.

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 Product Costs and
Period Costs an overview

2014 2015
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 COGS in media

Possible reasons for

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decrease in COGS?
 Quick Check 1
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.

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 Quick Check 1 solution
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.

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Inventoriable Product/Stock/ Costs—
Merchandiser
+ Purchase price from suppliers
+ Cost to get ready for sale
+ Freight-in
+ Import duties or tariffs

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 Inventoriable Product Costs—
Manufacturer
• Direct materials
• Direct labor Direct Costs
• Manufacturing overhead Indirect Costs

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Direct and Indirect Labor Costs Include

• Salaries and wages

• Fringe benefits
• Payroll taxes

Note that:
Indirect Labor Costs are Manufacturing
Overhead costs
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 Manufacturing Overhead
• Indirect costs 1) related to manufacturing
that are 2) not direct materials or direct
labor
– Indirect materials

– Indirect labor

– Other indirect manufacturing costs (rent,

electricity, supervisors, depreciation etc.)
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Stock/Product Versus Period Costs

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Manufacturing Cost Flows and
the Inventories
Balance Sheet Income
Costs Inventories Statement
Expenses
Material Purchases Raw Materials

Direct Labor Work in

Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold

Selling and Period Costs Selling and

Administrative Administrative
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Product Versus Period Costs

Illustration: Suppose you started your own snowboard

factory, KRT Boards. Here are some of the costs that your
snowboard factory would incur. Assign the following costs:

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Product Versus Period Costs

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 Product Versus Period Costs

If KRT Boards produces 10,000 snowboards the first year,

what would be the total manufacturing costs?

Cost 5, 6 and are not included. They are advertising,

sales and shipping costs.
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 Example Dairy Plains

If an
Inventoriable
COST Period Cost or Product Cost: Is
Inventoriable it DM, DL, or
Product Cost? MOH?
1. Cost of milk purchased from local dairy farmers
2. Depreciation on Marketing Department’s computers
3. Property tax on dairy processing plant
4. Gasoline used to operate refrigerated trucks
delivering finished dairy products to grocery stores
5. Company president’s annual bonus
6. Depreciation on refrigerated trucks used to collect
raw milk from local dairy famers
7. Plastic gallon containers in which milk is packaged
8. Research and development on improving milk
pasteurization process
9. Television advertisements for Dairy Plain’s products
10. Lubricants used in running bottling machines
11. Wages and salaries paid to machine operators at
dairy processing plant

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Example Dairy Plains Solution
If an
Inventoriable
COST Period Cost or Product Cost: Is
Inventoriable it DM, DL, or
Product Cost? MOH?
1. Cost of milk purchased from local dairy farmers
2. Depreciation on Marketing Department’s computers Product DM
3. Property tax on dairy processing plant Period
4. Gasoline used to operate refrigerated trucks Product MOH
delivering finished dairy products to grocery stores
Period
5. Company president’s annual bonus
6. Depreciation on refrigerated trucks used to collect Period
raw milk from local dairy famers
7. Plastic gallon containers in which milk is packaged Product MOH (or DM)
8. Research and development on improving milk Product DM
pasteurization process
9. Television advertisements for Dairy Plain’s products Period
10. Lubricants used in running bottling machines Period
11. Wages and salaries paid to machine operators at Product MOH
dairy processing plant
Product DL

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A bicycle company has these costs: tires, salaries of employees who put
tires on the wheels, factory depreciation, advertising expenditures,
lubricants, spokes, salary of factory manager, salary of accountant,
handlebars, and salaries of factory maintenance employees. Classify
each cost as direct materials, direct labor, overhead, or a period cost.

Direct Materials Direct Labor Overhead

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A bicycle company has these costs: tires, salaries of employees who put
tires on the wheels, factory depreciation, advertising expenditures,
lubricants, spokes, salary of factory manager, salary of accountant,
handlebars, and salaries of factory maintenance employees. Classify
each cost as direct materials, direct labor, overhead, or a period cost.

Direct Materials Direct Labor Overhead

 Tires.  Salaries of  Factory depreciation.
 Spokes. employees who put  Lubricants

tires on the wheels. 
Handlebars. Factory manager
salary.
 Factory maintenance
Advertising expenditures and salary
of accountant are period costs. employees salary.

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Preparing the financial statements
for service, merchandising, and
manufacturing companies

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Income Statement— Service Company

• Simplest income statement

• All costs are period costs
• No COGS

Service revenues
– Operating expenses
Operating income

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 Example Path Lab a service company

How would the income statement look?

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 Example Path Lab Solution
Path Lab
Income Statement
Year Ended December 2013
Service revenue $368,000
Less: Operating expenses
Marketing expense $28,000
Rental $18,000
Salary and benefit $100,000
Equipment depreciation expense $12,000
Website maintenance $5,000
Electricity $9,000
Supplies $12,000
Telephone bill $4,000
Total operating expenses $188,000
Operating Income $180,000

56
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Income Statement— Merchandiser

+ Sales
– Cost of goods sold
= Gross profit
– Operating expenses
= Operating income

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 Cost of Goods Sold Calculation—
Merchandiser
+ Beginning inventory
+ Purchases
+ Import duties or tariffs
+ Freight-in
= Cost of goods available for sale
– Ending inventory
= Cost of goods sold COGS

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 Aeon Big a Retailer Example
Aeon Big, a retailer, had recorded sales revenues of
$185,000,000 and other operating revenues of
$9,950,000 last year. Opening and ending inventory of
the year were $48,500,000 and $44,750,000,
respectively. Total purchases of the year were
$77,540,000, with freight-in and import duty adding
another $120,000. During the year Aeon Big incurred
selling and administrative expenses of 23,650,000.
Prepare:
1) A calculation of COGS and
2) Aeons Income statement for the year.

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 Aeon Big Example Solution
Aeon Big, a retailer, had recorded sales revenues of $185,000,000 and other
operating revenues of $9,950,000 last year. Opening and ending inventory of the
year were $48,500,000 and $44,750,000, respectively. Total purchases of the year
were $77,540,000, with freight-in and import duty adding another $120,000. During
the year Aeon Big incurred selling and administrative expenses of 23,650,000.
Prepare:
1) A calculation of COGS and
2) Aeons Income statement for the year.

Calculation of cost of goods sold (all figures shown in

thousands of dollars)
Beginning inventory $48,500
Plus: Purchases 77,540
Freight-in and import duty 120
Cost of goods available for sale 126,160
Less: Ending inventory 44,750
Cost of goods sold 81,410
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 Aeon Big Example Solution
Aeon Big, a retailer, had recorded sales revenues of $185,000,000 and other
operating revenues of $9,950,000 last year. Opening and ending inventory of the
year were $48,500,000 and $44,750,000, respectively. Total purchases of the year
were $77,540,000, with freight-in and import duty adding another $120,000. During
the year Aeon Big incurred selling and administrative expenses of 23,650,000.
Prepare:
1) A calculation of COGS and
2) Aeons Income statement for the year.

Aeon Big
Income Statement
(all figures shown in thousands of dollars)
Sales revenue $185,000
Less: Cost of goods Sold (see previous slide) 81,410
Gross profit 103,590
Plus: Other operating revenues 9,950
Less: Operating expenses
Selling and administrative expenses 23,650
Operating income 89,890
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 COGS for a Manufacturer
Direct Materials Used Calculation
+ Beginning raw materials inventory
+ Purchases of raw materials
+ Freight in
= Materials available for use
– Ending raw materials inventory
= Direct materials used

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 Cost of Goods Manufactured
Calculation—Manufacturer
+ Beginning work in process inventory
+ Direct materials used – from previous slide
+ Direct labor
+ Manufacturing overhead
= Total manufacturing costs to account for
– Ending work in process inventory
= Cost of goods manufactured - COGM

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 Cost of Goods Sold Calculation—
Manufacturer
+ Beginning finished goods inventory
+ Cost of goods manufactured (from
previous slide)
= Cost of goods available for sale
– Ending finished goods inventory
= Cost of goods sold (COGS)

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Comparison

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 Comparison Solution
Cost Items Manufacturing Merchandising Services

1. Cost of goods sold Yes √ Yes√ x

No
2. Rent expense Yes √ Yes √ Yes √
3. Marketing expense Yes √ Yes √ Yes√
4. Cost of goods manufactured Yes √ No x Nox
5. Customer service expense Yes √ Yes √ Yes√
6. CEO’s salary Yes √ Yes√ Yes√

66
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Padini – A retailer

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 Padini – A retailer Solution
Calculation of Cost of Goods Sold
Beginning inventory $66,400
Plus: Purchases 106,200
Freight-in and import duty 31,200
Cost of goods available for sale $203,800
Less: Ending inventory 54,800
Cost of goods sold $149,000

Value of the ending inventory

1096units * $ 50= $ 54,800
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Padini – A retailer Part 2

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Padini – A retailer Part 2 Solution
Padini
Income Statement
Sales revenue $357,500
Less: Cost of goods Sold 149,000
Gross profit $208,500
Less: Operating expenses 67,650
Operating income $140,850

Units sold = $149,000 / $50 = 2,980 units

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Income Statement—Manufacturer

+ Sales
– Cost of goods sold
= Gross profit
– Operating expenses
= Operating income

How do we find COGS?

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 Manufacturing Companies’
Inventory Accounts
Raw Materials Inventory
+ Beginning – Materials used
inventory
+ Purchases and in work in
freight process
= Ending
inventory

Please remember that an Inventory is an Asset account

and that assets increase on the Debit (left) side and
decrease on the Credit (right) side.
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 Manufacturing Companies’
Inventory Accounts
Work in Process Inventory

+ Beginning inventory – Cost of goods

+ Materials used from raw manufactured and
materials
+ Direct Labor sent to finished
+ Manufacturing overhead goods
= Ending inventory

Inside the factory

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 Manufacturing Companies’
Inventory Accounts
Finished Goods Inventory

+ Beginning – Cost of goods

inventory
+ Cost of goods sold
manufactured = Ending
inventory

Income statement
Balance sheet
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 Balance Sheet Differences
Type of Company Inventory Accounts

Service Company None

Merchandiser Merchandise inventory

Raw materials, work in process,

Manufacturer
and finished goods inventory

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An example of COGM (Cost of Goods Manufactured)
A manufacturer

• Kruger Bicycles had €50,000 of direct materials

stock at the beginning of the period.
• Purchases during the period amounted to
€180,000 and ending stock was €30,000.
• How much direct materials were used?

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An example of COGM (Cost of Goods Manufactured)
A manufacturer

• Kruger Bicycles had €50,000 of direct materials

stock at the beginning of the period.
• Purchases during the period amounted to
€180,000 and ending stock was €30,000.
• How much direct materials were used?
• €50,000 + €180,000 – €30,000 = €200,000

Remember the direct material for the next part of the example

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 An example of COGM
(Continued)
• Direct labour costs incurred were €105,500.
• Indirect manufacturing costs were €194,500.
• What are the total manufacturing costs incurred?

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 An example of COGM
(Continued)
• Direct labour costs incurred were €105,500.
• Indirect manufacturing costs were €194,500.
• What are the total manufacturing costs incurred?
• Direct materials used (previous slide)
€200,000 Direct labour
105,500 Indirect manufacturing costs
194,500
Total manufacturing costs
€500,000
Remember the 500 000 for the next part of the example

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 An example of COGM
(Continued)
• Assume that the work-in-progress stock
at the beginning of the period was €30,000,
and €35,000 at the end of the period.
• What is the cost of goods manufactured?

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 An example of COGM
(Continued)
• Assume that the work-in-progress stock
at the beginning of the period was €30,000,
and €35,000 at the end of the period.
• What is the cost of goods manufactured?
• Opening work-in-progress €30,000
+ Total manufacturing costs 500,000
– Closing work-in-progress 35,000
= Cost of goods manufactured €495,000

Please note the difference btw Manufacturing costs and

Cost of goods manufactured
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 An example of COGM
(Continued)
• Assume that the finished goods stock at the
beginning of the period was €10,000,
and €15,000 at the end of the period.
• What is the cost of goods sold (GOGS)?

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 An example of COGM
(Continued)
• Assume that the finished goods stock at the
beginning of the period was €10,000,
and €15,000 at the end of the period.
• What is the cost of goods sold? (COGS)
• Opening finished goods €10,000
+ Cost of goods manufactured 495,000
– Closing finished goods 15,000
= Cost of goods sold €490,000

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 An example of COGM
Same numbers as before presented
with T-accounts
Work-in-progress

Opening balance 30,000 495,000

Direct materials
used 200,000
Direct labour 105,500
Indirect
manufacturing costs 194,500
Closing balance 35,000
Answer: From
Question: Where did the 200,000
the Raw material
Direct Materials come from?
inventory
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 An example of COGM
Same numbers as before presented
with T-accounts

Work-in-progress (from previous slide) Finished goods

495,000 10,000 490,000
495,000
15,000

Cost of goods sold

490,000

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Cost of goods manufactured Schedule

The position of this

varies. Sometimes at
the top and sometimes
at the bottom

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Stock/Product Costs - A Closer Look
Schedule of Cost of Goods Manufactured
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials – Ending work in
inventory process inventory
= Raw materials used = Cost of goods
in production manufactured.

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Stock/Product Costs - A Closer Look
Schedule of Cost of Goods Manufactured
Work
In Process Finished Goods

Beginning work in Beginning finished

process inventory goods inventory
+ Manufacturing costs + Cost of goods
for the period manufactured
= Total work in process = Cost of goods
for the period available for sale
– Ending work in - Ending finished
process inventory goods inventory
= Cost of goods Cost of goods
manufactured sold

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 Schedule of Cost of Goods
Manufactured
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

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 Schedule of Cost of Goods
ManufacturedComputation 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
Raw material used $ 134,980
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

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 Schedule of Cost of Goods
Manufactured
Include all direct labor
costs incurred during the
Cometcurrent period.
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

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 Schedule of Cost of Goods
Computation of Total Manufacturing Overhead
Manufactured
Indirect material $ 10,000
Indirect labor 40,000
Depreciation on factory 90,000
Depreciation on equipment 70,000
Comet Computer Corporation
Utilities 15,000
Insuranceof Cost of Goods Manufactured
Schedule 5,000
Total manufacturing overhead $ 230,000
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

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 Schedule of Cost of Goods
Manufactured
Beginning work-in-
process inventory is
carried over from the
Comet Computer Corporation
prior period.
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

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 Schedule of Cost of Goods
Manufactured
Ending work-in-process inventory
contains the cost of unfinished
goods, and is reported in the current
Comet Computer Corporation
assets section of the balance sheet.
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

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 Income Statement for a
Manufacturer

Comet Computer Corporation

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

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 Income Statement for a
Manufacturer
Comet Computer Corporation
Schedule of Cost of Goods Sold
For the Year Ended December 31, 20X2

Finished-goods inventory, Jan. 1 $ 200

Add: Cost of goods manufactured 415,000
Cost of goods available for sale 415,200
Comet Computer Corporation
Deduct Finished-goods inventory, Dec. 31 190
Income Statement
Cost of goods sold $ 415,010
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

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Cost of Goods Manufactured

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Cost of Goods Manufactured

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 Exercise
• Purchases of raw material 690 000
• Ending raw material inventory 45 000
• Direct labour 135 000
• Beginning WIP inventory 120 000
• Salary CEO 43 000
• Ending WIP inventory 130 000
• Beginning raw material inventory 60 000
• Manufacturing overhead 370 000

Required:
Prepare a schedule of cost of goods manufactured during
the period. (There is also a little trap in the exercise).
What is Gross profit if beginning Fin goods inventory was
100 000 Net sales 1 400 000 and ending Fin goods
inventory was 120 000?
Write the above numbers in the Balance sheet and Income
statement Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved
 Solution to the first part above
Material inventory
Beg inventory 60
Purchases 690
Ending inventory -45
Material used in production 705

WIP inventory
Material used in production 705
Dir Labour 135
Manufacturing OH 370
Total manufacturing costs 1210
Beginning WIP 120
Ending WIP -130
Cost of Goods Manufactured (COGM) 1200

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 Solution to the above
Material inventory
Beg inventory 60 Balance Sheet
Purchases 690 Current Assets
Ending inventory -45 Raw Material 45
Material used in production 705 WIP 130
Fin Goods 120

WIP inventory
Material used in production 705 Income Stmt
Dir Labour 135 Net Sales 1400
Manufacturing OH 370 COGS 1180
Total manufacturing costs 1210 Gross Prof 220
Beginning WIP 120 Operating Exp.
Ending WIP -130 CEO Salary 43
Cost of Goods Manufactured (COGM) 1200

Finished Goods inventory

Cost of goods manufactured 1200
Beg inventory Fin Goods 100
Ending inventory Fin Goods -120
Cost of goods sold (COGS) 1180

What was the trap?

The CEO Salary is not COGM/COGS but an Op
Expense
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 Fixed and variable costs and
calculation of total and average
costs at different volumes

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 Cost Behavior

Change in total cost in direct

Variable
proportion to changes in
costs
volume

Stay constant in total cost over

Fixed costs
a wide range of activity levels

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 Total Variable Costs
Assume we pay 5% sales commissions on all sales.
The cost of sales commissions increases
proportionately with increases in sales.

$2,500
Commissions

$2,000
Total Sales

$1,500

$1,000
$500
$0
$0 $10,000 $20,000 $30,000 $40,000

Total Sales

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Total Fixed Costs: Stay Constant in
Total over a Wide Range of Activity
Levels
Total Sales Salaries $2,500
$2,000
$1,500

$1,000
$500
$0
$0 $10,000 $20,000 $30,000 $40,000

Total Sales

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 Types of Fixed Costs
Committed Discretionary
Long-term, cannot May be altered in the
be significantly short-term by current
reduced in the short managerial decisions
term

Can you give an example from a McDonalds restaurant?

Fixed assets such

The Ronald McDonald
as kitchen
clown entertaining kids
equipment
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 Total Cost
• Total cost = Fixed costs + (Variable cost
per unit x number of units)

Example:
Fixed costs = $20,000
Variable cost per unit = $50 per unit
Number of units = 100

Total cost = $20,000 + ($50 x 100)

= $25,000
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 Average Cost
• Total cost ÷ number of units = Average cost

Example:
$25,000 = $250 per unit
100 units

• The average cost per unit is NOT appropriate

for predicting total costs at different levels of
output.
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 Total costs and unit costs

• A unit cost (also called an average cost) is

computed by dividing some amount of cost total
by some number of units.
• The ‘units’ may be expressed in various ways:
– Hours worked
– Packages delivered
– Bicycles assembled.

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 Total costs and unit costs
(Continued)
• What is the unit cost (e.g. leasing and handlebars)
when Kruger Bicycles assembles 1,000 bicycles?
(Fixed cost € 94 500, Variable cost € 52/unit).
• Total fixed cost €94,500 + Total variable
cost €52,000 = €146,500
• €146,500 ÷ 1,000 = €146.50

Remember the €146.5/unit for the coming slides

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 Total costs and unit costs
(Continued)
• Total costs (€000)

€146.5

€94.5

0 1,000 Volume
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 Use unit costs cautiously

• Assume that Kruger Bicycles’ management uses

a unit cost of €146.50 (leasing and handlebars).
• Management is budgeting costs for different
levels of production.

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 Use unit costs cautiously
(Continued)
• What is their budgeted cost for an estimated
production of 600 bicycles?
600 × €146.50 = €87,900…..?
• What is their budgeted cost for an estimated
production of 3,500 bicycles?
3,500 × €146.50 = €512,750…..?

Note, the above figures are not correct. They

illustrate that using an average cost can be
misleading.
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 Use unit costs cautiously
(Continued)
• What should the budgeted cost be for an
estimated production of 600 bicycles?
• Total fixed cost €94,500
Total variable cost (€52 ×
600) = 31,200
Total €125,700
• €125,700 ÷ 600 = €209.50
• Using a cost of €146.50 per unit would
underestimate actual total costs if output is
below 1,000 units.
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 Use unit costs cautiously
(Continued)
• What should the budgeted cost be for an
estimated production of 3,500 bicycles?
• Total fixed cost €94,500
Total variable cost (52 ×
3,500) = 182,000
Total €276,500
• €276,500 ÷ 3,500 = €79.00

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 Use unit costs cautiously
(Continued)
• Using a cost of €146.50 per unit instead of
€79.00 would overestimate actual total costs if
output is above 1,000 units.
• For decision making, managers should think in
terms of total costs rather than unit costs.

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 Behaviour of manufacturing costs
Are they fixed or variable?
• Direct labour?

• Direct material?

• Manufacturing overhead costs

=Total manufacturing costs

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 Quick Check 2

Which of the following costs would be variable

with respect to the number of ice cream cones
sold at a Baskin & Robbins? (There may be
more than one correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.

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 Quick Check 2a

Which of the following costs would be variable

with respect to the number of ice cream cones
sold at a Baskin & Robbins? (There may be
more than one correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.

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 Cost drivers

• A cost driver is a factor, such as the level of

activity or volume, that causally affects costs
(over a given time span).
• The cost driver of variable costs is the level of
activity or volume whose change causes the
(variable) costs to change proportionately.
• The number of bicycles assembled is a cost
driver of the cost of handlebars.

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An Activity Base (Cost Driver)

Units Machine
produced hours

A measure of what
causes the
incurrence of a
variable cost

Miles Labor
driven hours
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 Relevant range

Relevant range is the band of the level of activity

or volume in which a specific relationship
between the level of activity or volume and the
cost in question is valid.
• Assume that fixed (leasing) costs are €94,500
for a year and that they remain the same for a
certain volume range (1,000 to 5,000 bicycles).
• The relevant range of bicycles is 1,000 to 5,000.

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 Relevant range (Continued)

• If annual demand for Kruger’s bicycles

increases, and the company needs to assemble
more than 5,000 bicycles, it would need to lease
additional space which would increase its fixed
costs.

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 Relevant range (Continued)

• Total fixed costs (€000)

€100.0
€94.5 Relevant range

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0 1,000 5,000 Volume
Fixed Costs and the Relevant Range

The relevant range of activity pertains to fixed cost as

well as variable costs. For example, assume office space
is available at a rental rate of $30,000 per year in
increments of 1,000 square feet.

Fixed costs would increase in a

step fashion at a rate of $30,000
for each additional 1,000 square
feet.

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 Relevant Range: Graphic

90
Rent Cost in Thousands of

The relevant range of

Relevant activity for a fixed cost
60
is the range of activity
Dollars

Range
over which the graph
of the cost is flat.
30

0
0 1,000 2,000 3,000
Rented Area (Square Feet)

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 The Linearity Assumption and the
Relevant Range
Economist’s A straight line
closely
Curvilinear Cost approximates a
Function curvilinear
variable cost
line within the
Relevant
relevant range.
Range
Total Cost

Accountant’s Straight-Line
Approximation (constant unit
variable cost)

Activity
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 Marginal Cost
• Cost of making one more unit

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 Prime costs

• Prime costs are all direct manufacturing costs.

+Direct Material
+Direct Labour
=Prime Cost

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 Conversion costs

Conversion costs are all manufacturing costs other

than direct materials cost. (I.e. the costs spent to
convert the material into a finished product).

+Direct labour
+Indirect manufacturing costs
=Conversion costs

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 Understand cost
classifications used in
making decisions:
differential costs, sunk
costs, and opportunity
costs.
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Cost Classifications for Decision
Making
• Decisions involve choosing between
alternatives. The goal of making decisions
is to identify those costs that are either
relevant or irrelevant to the decision.
• To make decisions, it is essential to have a
grasp on three concepts: differential costs,
sunk costs, and opportunity costs.

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 Differential Costs
Differential costs (or incremental costs)
are the difference in cost between any two
alternatives.
A difference in revenue between two
alternatives is called differential revenue.
Both are always relevant to decisions.
Differential costs can be either fixed or
variable.
What is a differential cost of McDonalds in Akmerkez
wants to decide if they should be open on Sundays?

Staff and electricity

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 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.

What is a sunk cost for

the McDonalds
restaurant in Akmerkez?

The interior which

cannot be reused in
another place
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 Opportunity Cost
The potential benefit that is
given up when one alternative
is selected over another.
These costs are not usually found in
accounting records but must be explicitly
considered in every decision.

It is possible to estimate opportunity costs of

for example buildings
For students:
a) What is the opportunity cost you incur by
attending this class?
b) What is the opportunity cost you incur by
attending
Copyrightuniversity?
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 A few examples
Let’s say that you are “lucky” and inherit a flat from a distant
relative. From an opportunity cost point of view, does that
mean that you “live for free”?

A doctor is offered to work extra over the weekend and will get
paid $1000 for that. She says no because she wants to visit
a new art exhibition because it offers free entrance for
doctors. What is her real cost for the art exhibition?

A hotel is fully depreciated in the Bal Sheet and accordingly not

an expense in the Inc Stmt. Do we therefore not include the
building cost when setting prices?

If you receive a box of very nice chocolate or a bottle of

champagne as a gift, does it have an opportunity cost if you
decide to eat/drink it? Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved
 Quick Check 3
Suppose you are trying to decide whether to drive
or take the train to Ankara 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
Ankara?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.
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 Quick Check 3a

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.
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 Quick Check 4

Suppose you are trying to decide whether to

drive or take the train to Ankara 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.

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 Quick Check 4a

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.

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 Quick Check 5

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.

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 Quick Check 5a

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.

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Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved