An Introduction to Cost Terms and Purposes

Basic Cost Terminology

Cost—a sacrificed or forgone resource to achieve a

specific objective.
Actual cost—a cost that has occurred (a historical or past

cost)
Budgeted cost—a forecasted, or a predicted cost(a future

cost)
Cost object—anything for which a cost measurement is

desired. 2- 2
Cost Object Examples at Tesla

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 Basic Cost Terminology
Cost accumulation—the collection of cost data in an organized

way by means of an accounting system.

Cost assignment—a general term that encompasses the

gathering of accumulated costs to a cost object in 2 ways:

Tracing accumulated costs with a direct relationship to the

cost object
Allocating accumulated costs with an indirect relationship

to a cost object.
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Cost assignment to a cost object

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 Cost classification by traceability
Direct costs Indirect costs
Costs that can be Costs cannot be easily and
easily and conveniently conveniently traced to a
traced to a cost objective. cost objective.
Examples: the cost of steel or Example: the salaries of
tires of Tesla Model 3s. plant administrators
(including the plant
manager)
Factors Affecting Direct/Indirect Cost
Classification
The materiality of the cost in question.
The available information-gathering technology.
Design of operations.

NOTE: a specific cost may be both a direct cost of one cost

object and an indirect cost of another cost object.

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Cost classification by behavior
Variable costs — change in total in proportion to

changes in the volume, or number of units achieved,

of the cost object.
Fixed costs — remain unchanged in total, for a given

time period, despite changes in the volume, or

number of units achieved, of the cost object.

Costs are fixed or variable only with respect to a specific

cost object and a given time period.
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Cost classification by behavior
Variable costs per-unit are constant.

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 per unit change inversely with the

level of production.

As more units are produced, the same fixed cost is spread

over more and2-more units, reducing the cost per unit. 9
 Variable Costs
Behavior of total and unit variable costs

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 Fixed Costs
Behavior of total and unit fixed costs

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 Other Cost Concepts
 Cost driver—a variable, such as the level of activity or volume, that

causally affects costs over a given time span.

Ex: The miles driven by trucks to deliver products are a cost driver of
distribution costs
 Relevant range—the band or range of normal activity level (or volume)

in which there is a specific relationship between the level of activity (or

volume) and the cost in question.

Ex: a fixed cost is fixed only for a given range of volume or activity (at which
the company is expected to operate) and only for a given time period
(usually a particular budget period).

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Relationships Between Types of Costs

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Total Costs and Unit Costs

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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) like legal advice or audits.

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 Types of inventory
Manufacturing-sector companies hold 3 types of inventory
Raw 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

Merchandising-sector companies hold only one type of

inventory: merchandise inventory
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Cost classification by functions

A. Manufacturing costs

(Product or Inventoriable costs).

B. Non-manufacturing costs

(Period costs).
 Direct
Direct Direct
Direct Manufacturing
Manufacturing
Materials
Materials Labor
Labor Overhead
Overhead

The Product
The acquisition costs of all materials that eventually become part
of the cost object; they can easily and unambiguously be traced
to the cost object

Example:
Example: A
A radio
radio installed
installed in
in an
an automobile
automobile
Those labor costs that can be easily and unambiguously be
traced to the cost object

Example:
Example: Wages
Wages paid
paid to
to automobile
automobile assembly
assembly workers
workers
Manufacturing costs that are related to the cost object, but that cannot
easily and unambiguously be traced to the cost object

Examples:
Examples: Indirect
Indirect materials
materials and
and indirect
indirect labor
labor
 Direct Direct Manufacturing
Material Labor Overhead

Prime Conversion
Cost Cost
 Administrative
Costs

All executive,
organizational, and clerical
costs.
Quick Check 
Which of the following costs would be considered
manufacturing overhead at Boeing? (More than one
answer may be correct.)

A. Depreciation on factory forklift trucks.

B. Sales commissions.

C. The cost of a flight recorder in a Boeing 767.

D. The wages of a production shift supervisor.

Inventoriable costs vs. Period costs
Product/ Inventoriable costs are all costs of a product that

are considered assets in a company’s balance sheet when the

costs are incurred and that are expensed as cost of goods sold
only when the product is sold. For manufacturing companies,
all manufacturing costs are inventoriable costs.
Period costs are all costs in the income statement other than

cost of goods sold. They are treated as expenses of the

accounting period in which they are incurred.
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Inventoriable costs include direct Period costs include all selling
materials, direct labor, and costs and administrative costs.
manufacturing overhead.

Expense
Inventory Cost of Good Sold

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.

 Income
Balance Sheet
Statement
Costs Inventories Expenses
Material Purchases Raw Materials

Direct Labor Work in

Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold

Selling and Period Costs Selling and

Administrative Administrative
Quick Check 

Which of the following transactions would immediately

result in an expense? (There may be more than one
correct answer.)
A. Work in process is completed.

B. Finished goods are sold.

C. Raw materials are placed into production.

D. Administrative salaries are accrued and paid.

AQUAS is a bottled water producer. It was established on Oct. 1, 2013.
Clever Man – the company’s accountant is required to prepare an income
statement to report on the first quarter performance.
AQUAS
Income Statement
For the quarter ended Dec. 31, 2013
(in VND mil.)
1. Sales 800
2. Expenses
Materials purchased 200
W ages for workers 100
W ages for marketing staff 50
Salaries for office clerks 60
Payment for Advertising 150
Plant rent 55
Office rent 65
Payment for office utility 120
Payment for plant utility 180
Total expenses 980
3. Loss (180)

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Cost flows illustrated

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Multiple-step income statement

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Multiple-step income statement

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Measuring Costs Requires Judgment

It is very important to clearly define and understand how

costs are measured in a particular situation or company.
Measuring a cost depends on the specific situation, purpose,

or question that management is trying to address.

Different companies or sometimes even different subunits

within the same company may define and classify costs

differently.

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Different product Costs for Different purposes

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 product Costs for Different purposes

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 Meaning of Different cost classifications
These different cost classifications help managers make decisions
and evaluate performance
1.Identify the problem and uncertainties: how much to price a product; how
much it costs to make the product.

2.Obtain information: identify the direct and indirect costs of a product in each
business function, and gather other information about customers, competitors,
the prices of competing products.

3.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.
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 Meaning of Different cost classifications
These different cost classifications help managers make decisions
and evaluate performance

4. Make decisions by choosing among alternatives: choose a price to

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

5. Implement the decision, evaluate performance, and learn: control

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

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Alternative Classifications of Costs

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 A framework for cost accounting
The following three features of cost accounting can be used for a wide
range of applications

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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