An Introduction To Cost Terms and Purposes

An Introduction to Cost Terms and Purposes
Copyright © 2015 Pearson Education,

1. Define and illustrate a cost object
2. Distinguish between direct costs and indirect costs
3. Explain variable costs and fixed costs
4. Interpret unit costs cautiously
5. Distinguish inventoriable costs period costs
6. Illustrate the flow of inventoriable and period
costs
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7. Explain why product costs are computed in
different ways for different purposes
8. Describe a framework for cost accounting and cost
management
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 Cost—a sacrificed or forgone resource to
achieve a specific objective.
 Actual cost—a cost that has occurred.
 Budgeted cost—a predicted cost.
 Cost object—anything for which a cost
measurement is desired.
Copyright © 2015 Pearson Education

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Cost Object Illustration
Product A BMW X6 sports activity vehicle
Telephone hotline providing information and
Service
assistance to BMW dealers
R&D project on DVD system enhancement in BMW
Project
cars
Herb Chambers Motors, a dealer that purchases a
Customer
broad range of BMW vehicles
Setting up machines for production or maintaining
Activity
production equipment
Department Environmental, Health and Safety department
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 Cost accumulation—the collection of cost data in
an organized way by means of an accounting
system.
 Cost assignment—a general term that encompasses
the gathering of accumulated costs to a cost object
in two ways:
 Tracing accumulated costs with a direct relationship to
the cost object and
 Allocating accumulated costs with an indirect
relationship to a cost object.
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 Direct costs can be conveniently and economically
traced (tracked) to a cost object.
 Indirect costs cannot be conveniently or
economically traced (tracked) to a cost object.
Instead of being traced, these costs are allocated to
a cost object in a rational and systematic manner.
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 Direct Costs
 Parts (steel or tires for a car, as an exampe)
 Assembly line wages
 Indirect Costs
 Electricity
 Rent
 Property taxes
 Plant administration expenses

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 The materiality of the cost in question.
 The available information-gathering technology.
 Design of operations.
 NOTE: a specific cost may be both a direct cost

of one cost object and an indirect cost of
another cost object.

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 Variable costs—change in total in proportion to
changes in the related level of activity or volume of
output produced.
 Fixed costs—remain unchanged in total, for a given
time period, despite changes in the related level of
activity or volume of output produced.
 Costs are fixed or variable only with respect to a
specific activity or a given time period.
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 Variable costs are constant on a per-unit basis. If a
product takes 5 pounds of materials each, it stays
the same per unit regardless if one, ten, or a
thousand units are produced.
 Fixed costs per unit change inversely with the level
of production. As more units are produced, the
same fixed cost is spread over more and more
units, reducing the cost per unit.
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Total Dollars Cost per Unit
Total
ChangeDollars
in Cost Per Unit
Change in
proportion with Unchanged in
Variable Costs proportion
output with relation to
Variable Costs output output
More output = More cost
More output = More cost
Change
Change
inversely with
inversely with
Fixed Costs Unchanged in
output
output
Unchanged
relation in
to output More output = lower
Fixed Costs More output = lower
relation to output cost
cost per unit
per
unit
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 Cost driver—a variable, such as the level of activity
or volume, that causally affects costs over a given
time span.
 Relevant range—the band or range of normal
activity level (or volume) in which there is a specific
relationship between the level of activity (or
volume) and the cost in question.
 For example, fixed costs are considered fixed only within
the relevant range.
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 Costs may be classified as:
 Direct/Indirect, and
 Variable/Fixed
 Thesemultiple classifications give rise to
important cost combinations:
 Direct and variable
 Direct and fixed
 Indirect and variable
 Indirect and fixed

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 Unitcosts should be used cautiously. Because unit
costs change with a different level of output or
volume, it may be more prudent to base decisions
on a total cost basis.
 Unit costs that include fixed costs should always
reference a given level of output or activity.
 Unit costs are also called average costs.
 Managers should think in terms of total costs rather than
unit costs for many decisions.
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 Manufacturing-sector companies purchase
materials and components and convert them
into finished products.
 Merchandising-sector companies purchase
and then sell tangible products without
changing their basic form.
 Service-sector companies provide services
(intangible products) like legal advice or
audits.

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 Direct materials—resources in-stock and
available for use
 Work-in-process (or progress)—products
started but not yet completed, often
abbreviated as WIP
 Finished goods—products completed and
ready for sale
 Note: Merchandising-sector companies hold

only one type of inventory: merchandise
inventory
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 Also known as inventoriable costs
 Direct materials—acquisition costs of all
materials that will become part of the cost
object.
 Direct labor—compensation of all manufacturing
labor that can be traced to the cost object.
 Indirect manufacturing—factory costs that are
not traceable to the product in an economically
feasible way. Examples include lubricants,
indirect manufacturing labor, utilities, and
supplies.

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 Inventoriable costs are all costs of a product that
are considered assets in a company’s balance sheet
when the costs are incured and that are expensed as
cost of goods sold only when the product is sold.
For manufacturing companies, all manufacturing
costs are inventoriable costs.
 Period costs are all costs in the income statement
other than cost of goods sold. They are treated as
expenses of the accounting period in which they are
incurred.
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 The Cost of Goods Manufactured and the
Cost of Goods Sold section of the Income
Statement are accounting representations of
the actual flow of costs through a production
system.
 Note how inventoriable costs to through the
balance sheet accounts of work-in-process and
finished goods inventory before entering the cost
of goods sold in the income statement.

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 Prime cost is a term referring to all direct
manufacturing costs (materials and labor).
 Conversion cost is a term referring to direct
labor and indirect manufacturing costs.
 Overtime labor costs are considered part of
indirect overhead costs.

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Because there are alternative ways for
management to define and classify costs,
judgment is required.
Managers, accountants, suppliers and others

should agree on the classifications and
meanings of the cost terms introduced in this
chapter and throughout the book.

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 Pricing and product-mix decisions—decisions
about pricing and maximizing profits
 Contracting with government agencies—very
specific definitions of allowable costs for “cost
plus profit” contracts
 Preparing external-use financial statements—
GAAP-driven product costs only

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The following three features of cost accounting and
cost management can be used for a wide range of
applications (for helping managers make decisions):
1. Calculating the cost of products, services, and

other cost objects
2. Obtaining information for planning and control,
and performance evaluation
3. Analyzing the relevant information for making
decisions

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An Introduction to Cost Terms and Purposes

Copyright © 2015 Pearson Education,

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 NOTE: a specific cost may be both a direct cost

Copyright © 2015 Pearson Education

Copyright © 2015 Pearson Education

Copyright © 2015 Pearson Education

 Note: Merchandising-sector companies hold

Copyright © 2015 Pearson Education

Copyright © 2015 Pearson Education

Copyright © 2015 Pearson Education

Managers, accountants, suppliers and others

Copyright © 2015 Pearson Education

Copyright © 2015 Pearson Education

1. Calculating the cost of products, services, and

Copyright © 2015 Pearson Education

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