Lecture 3 (Cost flows and cost terminology)

In this module, we will discuss how firms accumulate costs for financial reporting
purposes. We will examine the process of cost accumulation in three types of organizations:
service, merchandising, and manufacturing. We will scrutinize the similarities and differences in
the flow of costs in these organizations, focusing particularly on how they accumulate costs for
valuing inventory and reporting income. Because cost allocations play an integral role in this
process, we end our discussion of this module with a brief overview of the mechanics of cost
allocations. What we are going to discuss in this module is important because we need data to
estimate costs and benefits. Invariably, we get this data from the accounting system and most
systems are set up to comply with GAAP. Accordingly, it behooves us to understand how such
systems work.

All costs incurred are eventually recognized as expense in the income statement.
However, some costs are recognized as expenses immediately and some costs are recognized as
expense after a lag. The timing with which the costs of acquiring assets or services are
recognized as expense is an important issue in accounting. An expense is defined as the cost
incurred when an asset is used up or sold for the purpose of generating revenue. The terms
product cost and period cost are used to describe the timing with which various expenses are
recognized. A product cost is a cost assigned to goods that were either purchased for resale or
produced for sale. In the period of the sale, the product costs are recognized as an expense called
cost of goods sold. GAAP requires that costs are grouped according to business function.
Therefore, costs associated with production of goods and services or procurement of
merchandise is called product costs and they are not necessarily expensed in the period they are
incurred. All costs incurred in other business functions such as administration and marketing are
called period costs and they are expensed in the same period that they are incurred. For this
reason, they are called period costs. In the income statement, gross margin is calculated as the
difference between revenue and cost of goods sold. In this sense, you may say that product costs
appear above the line for gross margin. Another term for product cost is inventoriable cost,
since a product cost is stored as the cost of inventory until the goods are sold. On the other hand,
period costs are identified with the period of time in which they are incurred rather than with
units of purchased or produced goods and they are not inventoriable costs and therefore they
dont flow through inventory accounts. In the income statement, period costs are subtracted
from gross margin to arrive at the net income before taxes. In this sense, you may say that period
costs appear below the gross margin.

Companies such as American airlines, Hilton and KPMG are service firms. The key
distinction between a service firm and a non-service firm is the fact that the inputs and outputs

for a service firm are neither tangible nor storable. A physician can only provide a service when
a patient shows up! All costs associated with the business function of producing the services are
treated as product costs and expensed in the income statement as cost of providing services
above the line of gross margin. Other costs are expensed in the period they are incurred as
period costs.

Firms such as J.C.penney and Walmart are merchandising organizations. When they buy
merchandise, the cost of procurement of merchandise is added to the cost of inventory. At the
end of the accounting period, cost of goods sold is calculated as equal to cost of beginning
inventory plus cost of merchandise purchased minus the cost of ending inventory. Cost of goods
sold is the product costs that are expensed in the income statement above the gross margin line.
Costs other than the procurement cost of merchandise such as accounting and advertising cost
are treated as period costs and expensed in the same period that they are incurred.

Direct material, direct labor and manufacturing overhead are the three types of
manufacturing costs incurred by manufacturing firms. These costs are product costs because
they are stored in inventory and not expensed until the time period in which they are sold to
customers. Direct material is raw material that is consumed in the manufacturing process, is
physically incorporated in the final product and can be traced to products in an economically
feasible manner. Cost of tires is a direct material cost for an automobile company. Direct labor
cost is the cost of salaries, wages and benefits to personnel who work directly on the
manufactured products. Examples include a mechanic who assembles the tires for a car and a
painter who spray paints the car in a car manufacturing firm. Material and labor costs that are
not classifiable as direct costs are indirect costs.

In addition to labor and material, we have other manufacturing costs such as depreciation
of plant and equipment. Indirect material, indirect labor and all other non-material and non-labor
production costs are classified as manufacturing overhead costs. By definition, both direct and
direct labor costs are variable costs with respect to the cost driver of production volume.
Manufacturing overhead cost consists of a component that is variable and a component that is
fixed with respect to production volume. Manufacturing overhead costs are sometimes called
Capacity costs as these costs provide the firm the ability or capacity to manufacture goods.

Cost flows in manufacturing firms follow the physical flow of production process. When
raw material is purchased, the cost of material moves into the raw material inventory account.

As direct material is consumed in the production process, the cost of direct material is added to
work-in-process inventory account. Similarly, the cost of direct labor is added to the work-inprocess account as labor hours are consumed in the production process and manufacturing
overhead cost is applied to the work-in-process account. At the end of the production process, all
the accumulated cost is moved to finished goods inventory account. The total cost of direct
material, direct labor and manufacturing overhead transferred from work-in-process account into
finished goods inventory account is called the cost of goods manufactured. These costs are
stored in this inventory account until the time period when the products are sold. At that time,
the product costs are transferred from finished goods inventory account to cost of goods sold
account. Cost of goods sold is an expense of that particular period in which the sales are made.
On the other hand, the selling and administrative costs which are non-production costs are
expensed in the same period that they are incurred. GAAP prohibits attaching these costs to
inventory costs and therefore, they need to be expensed as soon as they are incurred. Also keep
in mind that these non-production costs can be fixed as well as variable with respect to the cost
driver of production volume.

The sum of direct material costs and direct labor costs are called prime cost. The term
prime costs refer to the fact that the sum of direct material and direct labor costs constituted
the lions share of product costs. While this is not necessarily the case today, this was true a long
time ago, when these terminologies were developed. The sum of direct labor costs and
manufacturing overhead is called conversion costs since these are the costs incurred by the firm
to convert the raw material into finished goods.

We next turn our attention to a very important issue. It is the issue of how firms assign
overhead costs to individual products. By definition, we can trace the direct material and direct
labor costs to individual products. We have a robust input-output relationship between every unit
of product manufactured and the cost of resources in the form of direct material and direct labor
given up in the production process. For example, for every car that is produced, Ford may be
spending 2 gallons of paint @ $10 a gallon and half an hour of labor time @ $50 per hour in
painting the car. Therefore, the direct material cost is $20 and direct labor cost is $25 per car
produced. On the other hand, manufacturing overhead costs are, by definition, not traceable to
individual products. While it is clear, that we need these productive resources in the form of
manufacturing overhead for the production process, it is not clear what the input-output
relationship is. We know that we need a paint spraying machine that may cost $ 1 million. But
we dont know how much of the value of $1 million of this paint spraying machine was used up
by the paint job we did for one car. Firms make some reasonable assumptions about the
relationship between overhead costs and the volume of individual products and allocate these
common costs. This procedure is called cost allocations.

A cost allocation is a procedure that allocates or distributes a common cost. Remember

that we defined in earlier module common cost as cost that is not unique but related to many cost
objectives or cost objects. Any cost allocation procedure has four elements. A cost pool is the
total cost to allocate or collection of costs to be assigned different cost objects. Cost objects are
the items or entities for which we desire a separate measurement of cost and therefore the
common costs need to be apportioned to each individual unit of the cost objects that are sharing
the common costs. Cost driver is some attribute that can be quantitatively measured easily for
the cost objects and is also called cost allocation basis. Allocation volume, also called
denominator volume, is the sum of the quantity of the cost driver across all cost objects that
share the common cost that is being allocated. Each cost allocation has two steps. The first step
involves calculating the allocation rate by dividing the amount of total cost in the cost pool by
the denominator volume. In the second step, we multiply the cost allocation rate by the number
of cost driver units contained in each cost object.

Let us look at a cost allocation example. Two families take a trip to San Antonio. Stan
and Amy are married and let us call them family 1. James is married to Gail and let us call them
family 2. At the last minute, Mark who is Gails brother decides to join them. They rent a car
and agree to share all travelling costs. On their way back, James and Gail get down in Austin
and only Stan and Amy drive back to Dallas. James and Gail were dropped in Dallas after a
couple of days by Mark. The total travel cost for the trip equals $400. This cost includes the car
rental cost and cost of gas. How should the two families share this cost? This is a cost allocation
problem.

There is more than one way in which we can allocate the common cost. Let us first
identify the four elements in this cost allocation problem. Here the cost pool is the transportation
cost between Dallas and San Antonio and is equal to $400. Cost objects are the two families
undertaking the trip since we desire to measure the cost of transportation for each family. All the
cots in this example are common costs that need to be allocated to each family individual who
took part in the trip. In method 1, we can take the number of families itself as the cost driver. In
this case, cost allocation rate is the total cost divided by the number of families which equals
$200. So each family is responsible for $ 200. This may not appear equitable as there are three
persons in one family and only two in another family. In method 2, we can treat the number of
persons undertaking the trip as the cost driver. The denominator volume is the sum of the
persons across all cost objectives which equals 2 + 3 = 5. The cost allocation rate = $400/5 =
$80 per person. In the next step, multiply the cost allocation rate by the number of cost driver
units contained in each cost object. Stans family has 2 persons and therefore the cost to be
allocated to Stans family = 3 X $ 80 = $160. Similarly cost allocated to James family = 4 X
$80 = $240. It is possible that some of you may feel that we have not taken into account the fact

that James family did not come back all the way to Dallas and instead got down in Austin. If
this is the perspective you take, then you may argue that James family is being overcharged. In
method 3, we consider the number of passenger miles driven as the cost allocation driver. For
the trip from Dallas to San Antonio, we have 5 persons travelling 320 miles. This amounts to
320 X 5 = 1,600 passenger miles. For the return trip, we have Stan and Amy travelling all the
way back to Dallas and this equals 320 X 2 = 640 passenger miles. However, Jamess family
travels only up to Austin and this implies that the total associated passenger miles equal 100 X 3
= 300 passenger miles. Let us sum up all the cost driver activity across the cost objectives. This
is equal to 2,540 passenger miles. Now the cost allocation rate = $400 divided by 2,540
passenger miles giving a cost allocation rate of 15.75 cents per passenger mile. How many
passenger miles did family 1 travel? This equals 640 + 640 = 1,280 passenger miles. Therefore,
Stans family gets allocated 1,280 X0.1575 = $201.58 as their share of common travel costs. The
number of passenger miles traveled by Jamess family equals = (320 X 3) + (100 X 3) = 1,260.
Therefore, Jamess family gets allocated 1,260 X 0.1575 = $198.42. Under each method, by
construction, the total cost allocated to the two families will sum up to the total cost in the cost
pool which is $400. Of course, we can think of many other ways of allocating the costs. It is
important to realize that there is seldom a unique way of allocating costs and we should pick a
method of cost allocation that mirrors the pattern of consumption of the underlying common
resource by the individual cost objects.

Cost allocation is a must from the standpoint of financial accounting. GAAP requires
that we measure the production costs of each product, inventory them until they are sold and
expense them when they are sold. In order to do this, we need to divide up the common
production costs in some manner between the products. Inventory valuation is the first use of
cost allocation. The second use of cost allocation is in managerial decision making. Managers
need to measure costs for each decision option and require cost measurement for each decision
option. Finally, cost allocation has a behavioral implication. To prevent managers from
consuming excessive amount of common resources, managers should be held accountable for the
cost of common resources in proportion to their consumption. Cost allocation facilitates this
measurement. GAAP requires common costs to be allocated in some manner. In other words,
the cost activity driver need not necessarily be the same as the cost allocation driver. On the
other hand, meaningful measurement of costs for managerial decisions requires that cost activity
driver be the same as the cost allocation driver or at least very closely related to it. To the extent
these two are not the same, quality of managerial decisions will be affected by poorly measured
costs. Allocated costs may give an appearance that a cost is variable. For example, the cost
allocation rate of $80 per person travelling may suggest that the transportation cost is variable
with respect to the number of people travelling. Realize that this cost is fixed and if for some
reason, only four people travel instead of five, you dont expect the total cost to come down by
$80. Therefore, you need to be careful when using allocated costs for decision making purposes.