CHAPTER 1

An Introduction to Cost Terms and Purposes

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Overview of Cost and Management
Accounting
Cost Accounting measures and reports
financial and nonfinancial information relating
to the cost of acquiring or consuming
resources in an organization. It provides
information for both management accounting
and financial accounting.
Management Accounting measures and reports
financial and nonfinancial information that helps
managers make decisions to fulfill the goals of
an organization. It focuses on internal
reporting.
Objectives of Cost Accounting:
 Fixing selling price,
 Making a foundation of total cost,
 Determining the profitable products,
 Controlling costs becomes easier,
 Helps in proper decision making,
 Enhances communication among
departmental managers, etc.
Objectives of Management Accounting:
 The primary objective of Management
Accounting is to enable management to
maximize profits or minimize losses,
 The fundamental objective of Management
Accounting is to provide relevant information
to managers for use in planning, controlling
operations and decision making.
Cost Accounting vs Financial Accounting
 Cost Accounting involves the preparation of a
broad range of reports that management
needs to run a business.
 Financial Accounting involves the preparation
of a standard set of reports for an outside
audience.
Management Accounting vs
Financial Accounting
 Management Accounting is designed to produce useful
information for a company’s internal use. Business
managers collect information that encourages strategic
planning, helps them se realistic goals, and encourages
an efficient directing of company resources,
 Financial Accounting has some internal use as well, but
it is much more concerned with informing those outside
of a company. Financial statements are designed to
disclose the firm’s business performance and financial
health.
Introduction
Accounting systems provide information useful to
users in the form of Financial Accounting and
Management Accounting reports
Cost Accounting is a bridge between them
Cost Accounting is a method for determining cost of a
product, service, project or thing.
Aids financial accounting by providing product cost
information to be reported in financial statements
Aids management accounting by providing cost
information to managers for performing their tasks-
planning and control.
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Basic Cost Terminology
Cost – sacrificed resource to achieve a specific objective
Actual cost – a cost that has occurred
Budgeted cost – a predicted cost
Expense – a cost that has given a benefit and now
expired.
Loss – unintentionally incurred in the context of
business operation
Cost object – anything of interest for which a separate
cost is desired.
 It may be a product, service, project, department, division,
branch, customer, etc
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Cost Object Examples at BMW
Cost Object Illustration
Product BMW X 5 sports activity vehicle
Service Dealer-support telephone hotline
Project R&D project on DVD system enhancement
Herb Chambers Motors, a dealer that
Customer purchases a broad range of BMW vehicles
Activity Setting up production machines
Department Environmental, Health & Safety

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Basic Cost Terminology
Cost accumulation – a collection of cost data in an
organized manner
Cost assignment – a general term that includes
gathering accumulated costs to a cost object. This
includes:
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 & Indirect Costs
Direct costs – can be conveniently and economically
traced (tracked) to a cost object.
Used by a single cost object
Avoided if the cost object is avoided
 Direct materials- cost of materials specifically used in manufacturing a
product. E.g. Lumber & metal frame cost in chair, cost of cottons in textile
factory, etc
 Direct labor-specific labor cost that can be identified with work involved in
production. E.g. salary, wages and fringe benefits for direct factory workers

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Direct & Indirect Costs
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
Can be classified in to
Those indirectly related to cost objects (common costs)
 E.g. salary of supervisors managing production, electricity,
rent, salary of janitors, property taxes, etc
Those directly related to cost object but is not
economically feasible to trace them.
 E.g. glues, nails, etc
BMW: Assigning Costs to a Cost Object

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Factors Affecting Direct / Indirect Cost
Classification
Cost Materiality
Availability of information-gathering technology
Operational Design

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Cost Behavior
Variable costs – change in total in proportion to changes in
the related level of activity or volume.
 DM, DL, IM, IL (in some instances), some selling & adm. exp
Fixed costs – remain unchanged in total regardless of
changes in the related level of activity or volume
 Salary of plant supervisor, depreciation exp., property taxes, etc
Semi-variable (mixed) costs- have both variable & fixed cost
portion. E.g. telephone and electricity costs
Semi-fixed (step-function) costs-fixed over some activity ranges
& change dramatically as level of activity moves from one range
to another.
Costs are fixed or variable only with respect to a specific
activity or a given time period
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Cost Behavior, continued
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 of one, ten or a thousand
units are produced
Fixed costs – change inversely with the level of
production on per unit basis. 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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Cost Behavior Summarized
Total Dollars
Total Dollars Cost per Unit
Cost Per Unit
Changein
Change in Unchanged in
proportion with
Variable Costs proportion with relation to output
Variable Costs output
output
Moreoutput
More output==More
Morecost
cost

Change inversely
Change inversely
Fixed Costs Unchanged in with output
Unchanged in with output
More output = lower cost
Fixed Costs relation to More output = lower cost
per unit
relation to output per unit
output

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Cost Behavior Visualized

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Other Cost Concepts
Cost Driver – a variable that causally affects costs over
a given time span. E.g. labor hours for labor cost, Kilowatt hours
for energy cost, no. of advertisements for adv. Expense, etc
 Fixed costs have no cost driver in the short run
 Cost driver is a cost allocation base for indirect costs

Relevant Range – the band of normal activity level (or

volume) in which there is a specific relationship
between the level of activity (or volume) and a given
cost
For example, fixed costs are considered fixed only within
the relevant range.
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Relevant Range Visualized

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A Cost Caveat
Unit costs should be used cautiously. Since unit costs
change with a different level of output or volume, it
may be more prudent to base decisions on a total
dollar basis.
Unit costs that include fixed costs should always
reference a given level of output or activity
Unit Costs are also called Average Costs

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Multiple Classification of Costs
Costs may be classified as:
Direct / Indirect, and
Variable / Fixed
These multiple classifications give rise to important
cost combinations:
Direct & Variable
Direct & Fixed
Indirect & Variable
Indirect & Fixed

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Multiple Classification of Costs, Visualized

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Other Cost Types
Differential & Marginal costs
Controllable and Noncontrollable costs
Opportunity costs
Sunk costs
Relevant and Irrelevant costs
Different Types of Firms
Manufacturing-sector companies – create and sell
their own products
Merchandising-sector companies – product resellers
Service-sector companies – provide services
(intangible products)

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Types of Manufacturing Inventories
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

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Types of Product Costs
Also known as Inventoriable Costs
Direct Materials
Direct Labor
Indirect Manufacturing – factory costs that are not
traceable to the product. Other common names for this
type of cost include Manufacturing Overhead costs or
Factory Overhead costs.

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Accounting Distinction Between Costs
Inventoriable costs – product manufacturing costs.
These costs are capitalized as assets (inventory) until
they are sold and transferred to Cost of Goods Sold.
Period costs – have no future value and are expensed
as incurred.

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Cost Flows
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 the importance of inventory accounts in the
following accounting reports, and in the cost flow chart

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Cost Flows Visualized

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Cost of Goods Manufactured

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Multiple-Step Income Statement

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Illustration
Assume the following information is available for the HH Company for February 200X.
Indirect manufacturing costs:
Beginning inventories: Indirect materials $15,000
Direct materials $15,000 Indirect labor 40,000
Work in process 38,000 Depreciation 50,000
Finished goods 26,000 Electric power 60,000
Ending inventories: Property taxes & Insurance 5,500
Direct materials 20,000 Repair and maintenance 25,000
Work in process 40,000 Miscellaneous 8,500
Finished goods 28,000 Selling and Administrative expenses 45,000

Direct materials purchased 90,000 Sales 625,000

Direct labor used 100,000

Required
Assume full absorption costing is used prepare an Income Statement and separate Schedule of Cost of
Goods Manufactured for the HH Company for February.
Other Cost Considerations
Prime cost is a term referring to all direct
manufacturing costs (labor and materials)
Conversion cost is a term referring to direct labor and
factory overhead costs, collectively
Overtime labor costs are considered part of overhead
due to the inability to precisely know the true cause of
these costs

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Different Definitions of Costs
for Different Applications
Pricing and product-mix decisions – may use a “super”
cost approach (comprehensive)
Contracting with government agencies – very specific
definitions of cost for “cost plus profit” contracts
Preparing external-use financial statements – GAAP-
driven product costs only

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Different Definitions of Costs
for Different Applications

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Three Common Features of
Cost Accounting & Cost Management
1. Calculating the cost of products, services, and other
cost objects
2. Obtaining information for planning & control, and
performance evaluation
3. Analyzing the relevant information for making
decisions

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