Chapter Two

Cost Terms, Concepts and

Classifications
After studying Topic 2, you should be able to:

1. Identify and give examples of each of the three

basic manufacturing cost categories.
2. Distinguish between product costs and period
costs and give examples of each.
3. Prepare an income statement including calculation
of the cost of goods sold.
4. Prepare a schedule of cost of goods manufactured.
5. Understand the term of cost driver.
After studying Topic 2, you should be able to:

6. Understand what is controllable and non

controllable costs.
7. Understand the differences between variable costs
and fixed costs.
8. Understand the differences between direct and
indirect costs.
9. Define and give examples of cost classifications used
in making decisions: differential costs, opportunity
costs, and sunk costs.
 Learning Objective 1

Identify and give examples of each of the

three basic manufacturing cost categories.
 Manufacturing Costs

1. Direct 2. Direct 3. Manufacturing

Materials Labor Overhead

The Product - Car

 Manufacturing Costs:
1. Direct Materials

Raw materials that become an integral part of the

finished product and whose costs can be conveniently
traced to the finished product and it is variable cost with
respect to products.

Example: A radio and the seats installed in an

automobile
 Manufacturing Costs:
2. Direct Labor

Those labour costs that can be easily traced to individual units of

product. Usually treated as variable costs, however contractual
arrangements sometimes mean that such labour is a committed
cost and so does not vary with the level of production

Example: Wages paid to automobile assembly workers

 Manufacturing Costs:
3. Manufacturing Overhead
Manufacturing Overhead is a cost that cannot be traced directly to
specific units produced. Also called indirect manufacturing costs

Examples: Indirect labor and indirect materials

Wages paid to employees who Materials used to support the

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

• Conversion costs
– The total of direct labour cost and manufacturing
overhead cost
– The cost of converting material into a product
• Prime costs
– The total of direct material cost and direct labour cost
– The major cost associated with producing a product
 Non-manufacturing Costs

Selling Administrative
Costs Costs

Costs necessary to get the

All executive, organizational,
order and deliver the
and clerical costs.
product.
 Learning Objective 2

Distinguish between product costs and

period costs and give examples of each.
 Product Costs Versus Period Costs

Product costs include direct Period costs include all

materials, direct labor, and operating costs i.e. selling
manufacturing overhead. costs and administrative
Also known as manufacturing costs.
costs

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
 Quick Check 
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.
 Quick Check 
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.
 Classifications of Costs

Manufacturing costs (or product costs) are often

classified as follows:

Direct Direct Manufacturing

Material Labor Overhead

Prime Conversion
Cost Cost
 Comparing Merchandising and
Manufacturing Activities
Merchandisers . . . Manufacturers . . .
– Buy finished goods. – Buy raw materials.
– Sell finished goods. – Process raw materials to
produce finished goods.
– Sell finished goods.

MegaLoMart
 Balance Sheet
For Merchandiser For Manufacturer

Current assets Current Assets

 Cash
Cash
 Receivables
Receivables
 Prepaid Expenses
Prepaid Expenses  Inventories:
Inventory • Raw Materials
• Finished goods • Work in Process
• Finished Goods
 Balance Sheet
Merchandiser Manufacturer

Current assets Current Assets

 Cash
Cash
 Receivables
Materials waiting to
Receivables
 Prepaid Expenses
be processed.
Prepaid Expenses  Inventories
Partially complete
Merchandise
products – some • Raw Materials
Inventory
material, labor, or • Work in Process
overhead has been • Finished Goods
added.
Completed products
awaiting sale.
 Learning Objective 3

Prepare an income statement

including calculation of the cost of
goods sold.
 The Income Statement
Cost of goods sold for manufacturers differs only slightly from
cost of goods sold for merchandisers.
Merchandising Company Manufacturing Company
Cost of goods sold: RM Cost of goods sold: RM
Beg. merchandise Beg. finished
inventory 14200 goods inv. 14200
+ Purchases 234150 + Cost of goods
Goods available manufactured 234150
for sale 248350 Goods available
- Ending for sale 248350
merchandise - Ending
inventory (12100) finished goods
= Cost of goods inventory (12100)
sold 236250 = Cost of goods
sold 236250
 Basic Equation for Inventory Accounts

Withdrawals
Beginning Additions Ending
balance + to inventory* = balance + from
inventory

•“Additions to Inventory” is subject to the type of business:

- For merchandising = purchase of finished goods
- For manufacturing business = produced its own goods
 Quick Check 

If your inventory balance at the beginning of the month was

$1,000, you bought $100 during the month, and sold $300
during the month, what would be the balance at the end of the
month?
A. $1,000.
B. $ 800.
C. $1,200.
D. $ 200.
 Quick Check 
If your inventory balance at the beginning of the
month was $1,000, you bought $100 during the
month, and sold $300 during the month, what would
be the balance at the end of the month?
A. $1,000.
$1,000 + $100 = $1,100
B. $ 800. $1,100 - $300 = $800
C. $1,200.
D. $ 200.
 Learning Objective 4
Prepare a schedule of cost of
goods manufactured.
 Schedule of Cost of Goods
Manufactured

Calculates the cost of raw material,

direct labor and manufacturing
overhead used in production.

Calculates the manufacturing costs

associated with goods that were
finished during the period.
 Cost flows in a manufacturing
business
• Material is purchased: the cost is added to raw materials
inventory
• Direct materials are consumed in production: cost is removed
from raw materials inventory and added to work in process
inventory
Direct labour and manufacturing overhead are accumulated in
work in process inventory

2-26
 Cost flows in manufacturing business ….continue

• Products are completed: costs are transferred from work in

process inventory and added to finished goods inventory
• Products are sold: costs are transferred from finished goods
inventory to cost of goods sold expense
Cost of goods sold is deducted from sales revenue to
determine gross profit
Cost flows in manufacturing business ….continue

• Raw materials, work in process and finished goods inventory

balances are reported in the balance sheet
• Cost of goods sold expense can be found in the income
statement
• The schedule of cost of goods manufactured and schedule of
cost of goods sold summarise the flow of manufacturing costs
 Cost flows in manufacturing
business ….continue

Inventorial costs Balance Sheet

Income Statement

Direct Raw materials

material inventory Sales Revenue

Direct Less
labour
Work in process Finished Cost of goods sold
Inventory goods
Manufacturing Equals
overhead
Gross Profit
Less

Selling and administrative

Period costs
expenses

Equals

Net Profit
 Quick Check 
Beginning raw materials inventory was $32,000. During the
month, $276,000 of raw material was purchased. A count at
the end of the month revealed that $28,000 of raw material was
still present. What is the cost of direct material used?
A. $276,000
B. $272,000
C. $280,000
D. $ 2,000
 Quick Check 
Beginning raw materials inventory was $32,000. During the
month, $276,000 of raw material was purchased. A count at
the end of the month revealed that $28,000 of raw material was
still present. What is the cost of direct material used?
A. $276,000 Beg. raw materials $ 32,000
+ Raw materials
B. $272,000 purchased 276,000
C. $280,000 = Raw materials available
for use in production $ 308,000
D. $ 2,000 – Ending raw materials
inventory 28,000
= Raw materials used
in production $ 280,000
 Quick Check 

Direct materials used in production totaled

$280,000. Direct labor was $375,000 and factory
overhead was $180,000. What were total
manufacturing costs incurred for the month?
A. $555,000
B. $835,000
C. $655,000
D. Cannot be determined.
 Quick Check 

Direct materials used in production totaled

$280,000. Direct labor was $375,000 and factory
overhead was $180,000. What
Direct were total $ 280,000
Materials

manufacturing costs incurred for the month?180,000

+ Direct Labor
+ Mfg. Overhead
375,000

A. $555,000 = Mfg. Costs Incurred

for the Month $ 835,000
B. $835,000
C. $655,000
D. Cannot be determined.
 Quick Check 
Beginning work in process was $125,000. Manufacturing
costs incurred for the month were $835,000. There were
$200,000 of partially finished goods remaining in work in
process inventory at the end of the month. What was the
cost of goods manufactured during the month?

A. $1,160,000
B. $ 910,000
C. $ 760,000
D. Cannot be determined.
 Quick Check 
Beginning work in process was $125,000. Manufacturing
costs incurred for the month were $835,000. There were
$200,000 of partially finished goods remaining in work in
process inventory at the end of the month. What was the
cost of goods manufactured during the month?
Beginning work in

A. $1,160,000 process inventory

+ Mfg. costs incurred
$ 125,000

B. $ 910,000 for the period 835,000

C. $ 760,000 = Total work in process
D. Cannot be determined.during the period
– Ending work in
$ 960,000

process inventory 200,000

= Cost of goods
manufactured $ 760,000
Format of Schedule of Cost of Goods
Manufactured

..\FORMAT SCHEDULE OF GOODS

MANUFACTURED.docx
 Quick Check 
Beginning finished goods inventory was $130,000. The cost of
goods manufactured for the month was $760,000. And the ending
finished goods inventory was $150,000. What was the cost of
goods sold for the month?

A. $ 20,000.
B. $740,000.
C. $780,000.
D. $760,000.
 Quick Check 
Beginning finished goods inventory was $130,000. The
cost of goods manufactured for the month was $760,000.
And the ending finished goods inventory was $150,000.
What was the cost of goods sold for the month?

A. $ 20,000.
B. $740,000. $130,000 + $760,000 = $890,000
C. $780,000. $890,000 - $150,000 = $740,000
D. $760,000.
 Learning Objective 5

Understand the term of cost driver

 Cost Driver

Definition (business dictionary)

 A factor that can causes a change in the cost of an activity.
 It is an activity that causes a cost to be incurred.
 An activity can have more than one cost driver attached to it. For
example, a production activity may have the following associated
cost-drivers: a machine, machine operator(s), floor space
occupied, power consumed, and the quantity of waste and/or
rejected output.
Cost drivers (cont.)

3-41
 Learning Objective 6

Understand what is controllable

and non controllable costs.
 Controllable and non controllable
costs
• Managers’ performance evaluation can be
enhanced by classifying responsibility centre
costs as either controllable by the manager or
uncontrollable
• Ideally, managers should be held responsible
only for costs they can control or significantly
influence
• Some costs are controllable in the long term but
not in the short term

2-43
Controllable and uncontrollable
costs (cont.)

2-44
 Learning Objective 7

Understand the differences between

variable costs and fixed costs.
Cost Classifications for Predicting
Cost Behavior

How a cost will react to changes in the

level of activity within the relevant
range.
– Total variable costs change when
activity changes.
– Total fixed costs remain unchanged
when activity changes.
 Variable Cost

Your total long distance telephone bill is based on

how many minutes you talk.
Total Long Distance
Telephone Bill

Minutes Talked
 Variable Cost Per Unit

The cost per long distance minute talked is constant.

For example, 10 cents per minute.

Telephone Charge
Per Minute

Minutes Talked
 Fixed Cost

Your monthly basic telephone bill probably does not

change when you make more local calls.
Telephone Bill
Monthly Basic

Number of Local Calls

 Fixed Cost Per Unit

The average fixed cost per local call decreases as

more local calls are made.

Monthly Basic Telephone

Bill per Local Call
Number of Local Calls
 Cost Classifications for Predicting
Cost Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Average fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.
 Quick Check 
Which of the following costs would be variable with respect to
the number of cones sold at a Baskins & Robbins shop? (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.
 Quick Check 
Which of the following costs would be variable with
respect to the number of cones sold at a Baskins &
Robbins shop? (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.
 Learning Objective 8

Understand the differences

between direct and indirect
costs.
 Assigning Costs to Cost Objects

Direct costs Indirect costs

• Costs that can be • Costs that cannot be easily
easily and conveniently traced and conveniently traced to a
to a unit of product or other unit of product or other cost
cost object. object.
• Examples: direct material and • Example: manufacturing
direct labor overhead
 How to differentiate between
direct to indirect cost?

 A particular cost may be direct or indirect, depending

on the cost object.
 For example: Campbell Soup factory that produces
dozens of varieties of canned soups.

 If the cost object is chicken noodle soup.

Factory manager’s salary falls under indirect cost.

 If the cost object is the entire manufacturing division

Factory manager’s salary falls under the direct cost
 Learning Objective 9

Define and give examples of cost

classifications used in making
decisions: differential costs, opportunity
costs, and sunk costs.
 Cost Classifications
for Decision Making
• Every decision involves a choice between at least two
alternatives.
• Only those costs and benefits that differ between
alternatives are relevant in a decision. All other costs and
benefits can and should be ignored.
 Differential Cost and Revenue
Differential cost:

• A difference in costs between any two alternatives is

known as differential cost.
• For example travelling to Langkawi: two alternatives either to
travel by bus or by airplane.
• Differential cost is a broader term encompassing of:
 Incremental cost – refers to an increase in cost from one
alternative to another;
 Decremental cost - refers to decrease in cost from one
alternative to another
 Differential Cost and Revenue
Differential revenue:

• A difference in revenues between any two alternatives

is known as differential revenue.
• For example - salaries offered by two different companies.
 Differential Cost and Revenue

Costs and revenues that differ among alternatives.

Example: You have a job paying $1,500 per month in your

hometown. You have a job offer in a neighboring city that pays
$2,000 per month. The commuting cost to the city is $300 per
month.

Differential revenue is:

$2,000 – $1,500 = $500

Differential cost is:

$300
 Opportunity Cost

The potential benefit that is

given up when one
alternative is selected over
another.

Example: If you were not attending

college, you could be earning
$15,000 per year. Your opportunity
cost of attending college for one year
is $15,000.
 Opportunity Cost….example

Example 1:
Vicki has a part-time job that pays RM200 per week while attending college. She
would like to spend a week at the beach during spring break, and her employer has
agreed to give her the time off, but without pay. The RM200 in lost wages would be
an opportunity cost of taking the week off to be at the beach.

Example 2:
Steve is employed by a company that pays him a salary of RM38,000 per year. He is
thinking about leaving the company and returning to school. Because returning to
school would require that he give up his RM38,000 salary, the forgone salary would
be an opportunity cost of seeking further education.
 Sunk Costs

Sunk costs have already been incurred and cannot be

changed now or in the future. They should be ignored
when making decisions.

Example: You bought an automobile that cost $10,000 two

years ago. The $10,000 cost is sunk because whether you
drive it, park it, trade it, or sell it, you cannot change the
$10,000 cost.
 Quick Check 
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.
 Quick Check 
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.
 Quick Check 
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.
 Quick Check 
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.
 Quick Check 
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.
 Quick Check 
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.
 Summary – the purpose of cost
classifications

The purpose of cost classifications are for:

• Financial reporting
• Predicting cost behavior
• Assigning costs to cost objects
• Decision making
 Basic of Cost classifications Used to:
classification
Behaviour Variable (proportional to Plan (budget) costs
activity Control costs
Fixed Make decisions
•Traceability •Direct (can easily traced) •Estimate the COGS
•Indirect (cannot be easily •Estimate the cost of organisational units,
traced) such as departments or activities.
•Controllability •Controllability •Measure managers’ performance
•Uncontrollability •Control costs
•Manufacturing •Direct material •Estimate the cost of products
/product costs •Direct labour •Estimate the cost of goods sold for the
•Manufacturing overhead income statement, and inventory for
balance sheet.
•Prepare income statement and balance
sheet.
•Making decisions •Differential costs •To differentiate among costs that are
•Differential revenue relevant and/or irrelevant in making
•Sunk costs decisions.
•Opportunity costs