An Introduction to Cost Terms and Purposes

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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
Cost object—anything of interest for which a cost is
desired

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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 and 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 and Indirect Costs
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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BMW: Assigning Costs to a Cost
Object

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Cost Examples
Direct Costs
Parts
Assembly line wages
Indirect Costs
Electricity
Rent
Property taxes

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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—changes in total in proportion to
changes in the related level of activity or volume.
Fixed costs—remain unchanged in total regardless of
changes in the related level of activity or volume.
Costs are fixed or variable only with respect to a
specific activity or a given time period.

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Cost Behavior
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 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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Cost Behavior Summarized
Total Dollars
Total Dollars Cost per
Per Unit
Unit
Change in
Change in Unchanged in
Variable Costs proportion with
proportion with relation to output
Variable Costs output
output
Moreoutput
More output==More
Morecost
cost
Change
Change inversely
Fixed Costs Unchanged in inversely with
Unchanged in with output
Fixed Costs output
relation to output More output = lower cost
relation to output More output = lower cost
per unit
per unit

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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
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. Because 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.
Managers should think in terms of total costs rather
than unit 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 and variable
Direct and fixed
Indirect and variable
Indirect and fixed

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Multiple Classification of Costs,
Visualized

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Different Types of Firms
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).

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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—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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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
in the period 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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Multiple-Step Income Statement
PANEL A: INCOME STATEMENT
Cellular Products
Income Statement
For the Year Ended December 31, 2011 (in thousands)
Revenues $210,000
Costs of goods sold:
Beginning finished goods inventory, January 1, 2011 $22,000
Costs of goods manufactured (see Panel B) $104,000
STEP 4 Costs of goods available for sale $126,000
Ending finished goods inventory, December 31, 2011 $18,000
Cost of goods sold $108,000
Gross margin (or gross profit) $102,000
Operating costs
R&D, design, mktg., dist., & cust.-service cost $70,000
Total operating costs $70,000
Operating income $32,000

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Cost of Goods Manufactured
PANEL B: COST OF GOODS MANUFACTURED
Cellular Products
Schedule of Cost of Goods Manufactured*
For the Year Ended December 31, 2011 (in Thousands)
Direct materials:
Beginning inventory, January 1, 2011 $11,000
Purchases of direct materials $73,000
STEP 1 Cost of direct materials available for use $84,000
Ending inventory, December 31, 2011 $8,000
Direct materials used $76,000
Direct manufacturing labor $9,000
Manufacturing overhead costs:
Indirect manufacturing labor $7,000
Supplies $2,000
Heat, light, and power $5,000
STEP 2 Depreciation-plant building $2,000
Depreciation-plant equipment $3,000
Miscellaneous $1,000
Total manufacturing overhead costs $20,000
Manufacturing cost incurr3ed during 2011 $105,000
Beginning work-in-progress inventory, January 1, 2011 $6,000
STEP 3 Total manufacturing costs to account for $111,000
Ending work-in-progress inventory, December 31, 2011 $7,000
Cost of goods manufactured (to income Statement) $104,000
* Note that this schedule can become a Schedule of Cost of Goods M anufactured and Sold simply by including the beginning and
ending finished goods inventory figures in the supporting schedule rather than in the body of the income statement.

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Other Cost Considerations
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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Different Definitions of Costs
for Different Applications
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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Different Definitions of Costs
for Different Applications

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Three Common Features of
Cost Accounting and Cost
Management
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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© 2012 Pearson Prentice Hall. All rights reserved.