CHAPTER 2: AN INTRODUCTION TO COST TERMS AND

PURPOSES

1. Define and illustrate a cost object

- Costs and Cost Terminology
+ Cost: is the monetary value of resources (such as labor)
sacrificed or forgone to achieve a specific objective.
+ Actual cost: is a cost that has been incurred (a historical or
past cost).
+ Budget cost: is a forecasted, or predicted, cost (a future
cost).
+ Cost object: is anything for which a cost measurement is
desired.
+ Cost accumulation: is the collection of cost data in some
organized way by means of an accounting system.

2. Distinguish between direct costs and indirect costs

2.1.Definition:
- Direct costs: Costs that can be easily and conveniently traced to
a cost objective
Ex: the cost of steel or tires of Tesla Model 3s.
- Indirect costs Costs can't be easily and conveniently traced to a
cost objective
Ex: the wages of plant administrators
- Cost allocation is used to describe the process of assigning
indirect costs to a particular cost object
- Cost assignment is a general term that encompasses both
tracing direct costs to a cost object and allocating indirect costs to
a cost object.

2.2.Cost allocation challenges:

- Misleading managers about the profitability of different products,
making them unknowingly promote less-profitable products instead
of more-profitable products.
- Allocating other indirect costs is more difficult as measuring the
share of plant administration used by each car model is not clear-
cut.
2.3.Factors Affecting Direct/Indirect Cost Classifications
- The materiality of the cost in question and available information-
gathering technology: The smaller the amount of a cost—that is,
the more immaterial the cost is—the more likely it is to be
classified as an indirect cost.
- Design of operations: Classifying a cost as direct is straightforward
if a company’s facility (or some part of it) is used exclusively for a
specific cost object, such as a specific product or a particular
customer.

3. Explain variable costs and fixed costs

3.1. Fixed cost vs variable cost

Fixed cost vs variable cost is the difference in categorizing

business costs as either static or fluctuating when there is a change in
the activity and sales volume. Fixed cost includes expenses that remain
constant for a period of time irrespective of the level of outputs, like rent,
salaries, and loan payments, while variable costs are expenses that
change directly and proportionally to the changes in business activity
level or volume, like direct labor, taxes, and operational expenses.

Compare between fixed costs and variable costs

Fixed Costs Variable Costs

Meaning In accounting, fixed Variable costs are expenses

costs are expenses that that change directly and
remain constant for a proportionally to the changes
period of time in business activity level or
irrespective of the level volume.
of outputs.

Incurred Even if the output is nil, The cost increases/decreases

when fixed costs are incurred. based on the output
 Also Fixed costs are also Variable costs are also
known as known as overhead referred to as prime costs or
costs, period costs or direct costs as it directly
supplementary costs. affects the output levels.

Nature Fixed costs are time- Variable costs are volume-

related i.e. they remain related and change with the
constant for a period of changes in output level.
time.

Examples Depreciation, interest Commission on sales, credit

paid on capital, rent, card fees, wages of part-time
salary, property taxes, staff, etc.
insurance premium, etc.

3.1.1. Fixed Costs Example

Fixed costs remain constant for a specific period. These costs are often

time-related, such as the monthly salaries or the rent.

For example, the rent of a building is a fixed cost that a small business

owner negotiates with the landlord based the square footage needed for

its operations. If the owner rents 10,000 square feet of space at $40 a

square foot for ten years, the rent will be $40,000 per month for the next

ten years, regardless of the profits or losses.

It is important to note that fixed costs are not constant in the long run.

Take the example above. The rent will be the same till the business

occupies the space or till the landlord decides to increase the rent after

the end of the lease agreement. If the owner decides to move to a bigger

facility or pay more, the business expense would obviously go up.

3.1.2. Variable Costs Example

Variable costs change directly with the output – when output is zero, the
variable cost will be zero. The total variable cost to a business is
calculated by multiplying the total quantity of output with the variable cost
per unit of output.

A common example of variable costs is operational expenses that may

increase or decrease based on the business activity. A growing business
may incur more operating costs such as the wages of part-time staff
hired for specific projects or a rise in the cost of utilities – such as
electricity, gas or water.

Unlike fixed expenses, you can control your variable expenses to leave
room for profits.

4. Interpret unit costs cautiously

Toltal costs and unit costs

Aspect Total Costs Unit Costs

Cost incurred to produce a

Overall expenses for a single unit of a product or
Definition given level of production service

Total Costs = Fixed Costs + Unit Costs = Total Costs /

Calculation Variable Costs Number of Units

Encompasses all costs for a Focuses on the cost per unit

Scope specific level of production produced

Formula Total Costs Unit Costs

Component Fixed Costs and Variable Total Costs divided by

s Costs Number of Units

Pricing, cost control,

Budgeting, financial performance evaluation at the
Usage planning, capacity decisions unit level

Decision- Overall production capacity, Pricing decisions, product mix,

Making expansion or contraction cost control at the unit level

Unit cost, also known as average cost or per-unit cost, refers to the
average cost incurred by a business to produce a single unit of a product
or service. It is a financial metric that helps analyze and assess the
efficiency of production processes, as well as make pricing decisions.
The unit cost is calculated by dividing the total cost of production by the
number of units produced.

Unit cost is a valuable metric for businesses as it provides insights into

the cost efficiency at the individual unit level. It is frequently used for
pricing decisions, cost control, and evaluating the financial performance
of a product or service. Businesses strive to manage and reduce unit
costs to enhance profitability and competitiveness in the market.

5. Distinguish the financial accounting concepts of inventoriable

costs and period costs
- 3 types of company:

Manufacturing- Merchandising- Services- sector

sector companies: sector companies: companies:
purchase raw purchase and then provide intangible
materials and sell tangible products products to their
components then without changing their customers
convert them into form ex: banks, insurance/
finished goods - Retailing transportation
ex: Apple (computer - Distribution companies,..
companies), Ford - Wholesaling
(automotive
companies), Pizza hut
(food processing
companies),...

Types of Inventory in
this company:
- Direct material
inventory: stored in
stock and used in the
manufacturing
process
- Work in process
inventory: partially
work on and not yet
completed
- Finished goods
inventory: completed
but not yet sold

Manufacturing Costs Inventoriable Costs Period Costs (non

manufacturing
costs)
-> The costs that are - Inventoriable - Period costs are all
incurred in making a (Product ) costs are all costs in the income
product. costs of a product that statement other than
- Direct materials: are considered assets cost of goods sold.
acquisition cost of all in a company’s - They are treated as
materials balance sheet when expenses of the
- Direct labor: the costs are incurred accounting period in
Compensation of all and that are expensed which they are
manufacturing labor as cost of goods sold incurred
- Indirect only when the product - Include selling and
manufacturing is sold. administrative costs
overhead: - For manufacturing
+ Indirect material companies, all
costs: Materials manufacturing costs
used to support are inventoriable costs
the production
process
+ Indirect labor
costs: Wages
paid to
employees who
are not directly
involved in
production (ex:
security guards,
 janitors,..)

6. Illustrate the flow of inventoriable and period costs in financial

accounting

Ending balance= Beginning balance+ Additions to inventory -

withdrawals from inventory

Statement of COGS:
Step 1: Compute the cost of direct materials used during the
period

Costs of Direct Materials Used= Materials Inventory Beginning Balance

+Direct Materials Purchased - Materials Inventory Ending Balance

Step 2: Calculate total manufacturing costs for the period

Total Manufacturing Costs= Cost of Direct Materials Used + Cost of

Direct Labor - Total Manufacturing Overhead Costs
 Step 3: Determine total cost of goods manufactured for the
period

Costs of Goods Manufactured= WIP Inventory, Beginning Balance +

Total Manufacturing Costs - WIP Inventory, Ending Balance

Step 4: Determine total cost of goods manufactured for the

period

Costs of Goods Sold= Finished Goods Beginning Balance + Cost of

Goods Manufactured - Finished Goods Inventory, Ending Balance

7. Measuring Costs Requires Judgement

- The best way to measure a cost depends on specific

situations, purposes or questions striving for address.

- It’s important to clearly define and understand how costs

are measured in a particular situation or company

Labor costs

- Direct programming labor costs ( can be traveled to

individual products )

- Overhead costs

+ Indirect labor costs

+ Salaries for managers, department heads, and supervisors

+ Payroll fringe costs

Note:

Although labor costs classifications vary among companies, many

companies use multiple labor cost categories and
subclassifications as above. In general, salaries of those regarded
as management are placed in a separate classification of labor-
related overhead and not classified as indirect labor costs.

Benefits of Defining Accounting Terms

- Avoid many problems if it clearly defines, understands, and

agrees how costs are measured when engaged with each other.

- In order to prevent disputes, contracts and laws should be

as specific as possible about definitions and measurements.

Different Meanings of Product Costs

- Pricing and product-mix decisions

- Reimbursement under government contracts

- Preparing financial statements for external user under

GAAP – calculating inventory cost

Meaning of Different cost Classifications

Identify the problem and uncertainties: how much to price a

product; how much it costs to make the product
 Obtain information: identify the direct and indirect costs of a
product in each business function, and gather information about
customers, competitors, the prices of competing products.

Make predictions about the future: estimate what it will cost to

make the product in the future; predict the quantity of the product
they expect the company to sell as well as have an understanding
of fixed and variable costs.

Make decisions by choosing among alternative: choose a price to

charge based on a thorough understanding of costs and other
information.

Implement the decision, evaluate performance, and learn: control

costs and learn by comparing the actual costs and unit costs
against budgeted amounts

Alternative Classifications of Costs

8. A Framework for Cost Accounting and Cost Management

The following three features of cost accounting can be used fot a

wide range of applications:

- Calculating the cost of products, services and other cost

objects
- Obtaining information for planning and control, and
performance evaluation
- Analyzing the relevant information for making decisions