Cost Concepts and

Behavior

Chapter
2

2-1

Learning Objectives
1. Explain the basic concept of cost.
2. Explain how costs are presented in financial
statements.
3. Explain the process of cost allocation.
4. Understand how material, labor, and overhead
costs are added to a product at each stage of the
production process.
5. Define basic cost behaviors including fixed,
variable, semivariable, and step costs.
6. Identify the components of a products costs.
7. Understand the distinction between financial and
contribution margin income statements.

2-2

What is a
L.O. 1 Explain the basic concept of
Cost? cost. Cost
a sacrifice of resources
Outlay Cost

Opportunity Cost

past, present, or
future cash
outflow

forgone benefit
from best
alternative
course of action
Expense

Cost charged against

revenue in an accounting
period

2-3

2-4

Cost Example
Josh wants to buy a new surfboard.
If he buys the surfboard he cant go
on a spring break ski trip with his
friends.

Cost of
surfboard?

Outlay Cost

$500
purchase
price of the
surfboard

Opportunity Cost

No
spring
break
trip

2-5

Cost
Example
Your education costs?

Outlay Cost

The cost
of
tuition

Opportunity Cost

The $15,000
you could
make
flipping
burgers

Recording Costs in Financial

Statements
L.O. 2 Explain how costs are presented in financial
statements. Income Statements

Service
Company

Merchandise
Company

Service revenues
- Cost of services
sold
= Gross margin
- Marketing and
administrative
costs

= Operating profit

Sales revenues
Cost
incurred to
purchase
the goods
sold
Cost of
billable
hours

- Cost of goods
sold
= Gross margin
- Marketing and
administrative
costs

= Operating profit

The excess of operating revenue

over cost necessary to generate
those revenues

2-6

Manufacturing Company
Costs
Manufacturing Costs
Product Costs

Inventoriable Costs

Costs incurred to
manufacture a product

Period Costs

Nonmanufacturing Costs

Costs incurred to sell

a product and operate
the business

Recorded as an asset
in inventory when
cost is incurred
Recognized as an
expense when product
is sold

Recognized as an
expense when cost is
incurred

2-7

2-8

Income Statement
Manufacturing
Company
Sales revenues
- Cost of goods
sold
= Gross margin
- Marketing and
administrative
costs
= Operating profit

Cost incurred
to
manufacture
the product
sold
Period costs
recorded as an
expense when
cost is
incurred.

Product
costs
recorded as
an asset in
inventory
when cost is
incurred.
Recognized
as an
expense
when the
product is
sold.

Manufacturing Costs

Inventory Costs
Product
Recognized as an expense when product is
Recorded
as an asset in inventory when cost is
Costs
sold

incurred
Direct

Costs

Cost that can be directly

traced to the product

Direct Materials
Materials directly traceable
to the product.

Direct
Labor

Work directly traceable to

transforming material into
finished product

Indirect Costs
Cost that cannot be
directly traced to the
product

Manufacturing
Overhead
All production costs except
direct materials and direct
labor.
Indirect
Materials
Indirect
Labor
Other Indirect
Costs

2-9

2-10

Traceability of Costs
Josh decides to go on the
spring break ski trip. He is off
to the slopes.
Identify the
This ski
object
trip
Direct Cost

Cost
of lift
ticket
s

Indirect Cost

The original
cost of his
equipment

2-11

Traceability of
Cost
Your education
costs?
Identify the
object

This
class

Direct Cost

Indirect Cost

The cost of
your
textbook

The cost
of full
time
tuition

Manufacturing Costs

2-12

Product
Costs
Inventory Costs
Prime Costs

Direct Materials

The primary
cost of the product

Direct
DirectLabor
Labor

Conversion Costs

Direct Labor

Cost necessary to
convert materials
into a product

Manufacturi
ng Overhead

Product Cost
Review
Direct Materials =
$8
Direct Labor = $7
Manufacturing
overhead = $14

Direct
DM + DL =
cost?
$15

2-13

Prime
DM + DL =
cost?
$15

Conversion
DL + MOH =
cost?
$21

Indirect
MOH =
cost?
$14

Total Product
DM + DL + MOH =
Cost
$29

2-14

Period
Costs
Nonmanufacturing Costs
Recognized as an expense when cost is
incurred

Marketing

Administrative

Costs necessary
to sell the
products

Costs necessary to
operate the
business

Advertising

Executive salaries

Sales
commissions
Shipping costs

Data processing
Legal costs

Cost
L.O. 3 Explain the process of cost
Allocation
allocation.
The process of assigning indirect cost to a cost object
1. Define

Pool
2. Determine

Cost
Collection of costs to be assigned to cost
objects

Cost Allocation Rule

Method used to assign costs in the cost pool to
the cost objects

3.
Assign

Cost
Object
Any end to which a cost is assigned
Product

Department

Product
Line

Customer

2-15

Rockford
Corporation
East Coast
Revenues

80
million

Cost
objects

West Coast

Total

20
million

100 million

Corporate Information
Systems Costs of
$1,000,000

Cost pool

Cost
allocatio
n rule

2-16

IS costs
allocated
based on
division
revenue

%
Revenue
80%

$80
million

$20
million

20%

East Coast

West
Coast

$800,000

$200,000

2-17

Manufacturing Cost
L.O. 4 Understand how manufacturing costs are added to a
Flows
product.
Product costs recorded in inventory when cost
incurred.
A manufacturing company
has three inventory
accounts.
Inventory: Current asset

Also called
Inventoria
ble Costs

representing materials and goods on

hand

Raw
materials
Materials
purchased to
make
product

Work-in-process Finished
goods
Product in
production
process, but not
yet complete

Product fully
completed but
not yet sold.

2-18

The Inventory
Raw
Work-InAccounts
Materials
Beg.
Inventory
+Purchases

= Raw
Materials
Available for
Production
- Raw
Materials
Transferred to
WIP
= Ending
Inventory

Process

Beg. Inventory

+ Direct Materials
Transferred from
Raw Materials
+ Direct
Labor
+ Manufacturing
Overhead
= Total
Manufacturing
Costs
- Cost of Goods
Completed and
Transferred to
Finished Goods
= Ending Inventory

Balance Sheet

Finished
Goods

Beg.
Cost of Goods
+ Inventory
Completed and
Transferred from
WIP
= Goods
Available for
Sale
Cost of
Goods
Sold
= Ending
Inventory
To the
income
statement

2-19

Jackson Gears

Jackson Gears
Cost of Goods Manufactured
For the YearStatement
Ending December 31,
200X
Beginning Work-In-Process Inventory, January 1

$270,000

Manufacturing cost during the year:

Direct Materials
Beginning Inventory, Jan. 1
Add Purchases
Direct Materials Available

95,000
5,627,000
$5,722,000

Less Ending Inventory, Dec. 31

72,000

Direct Materials put into production

5,650,000

Direct Labor

1,220,000

Manufacturing Overhead

6,780,000

Total Manufacturing cost incurred

13,650,000

Total Work-In-Process during the year

13,920,000

Less Ending Work-In-Process Inventory, Dec. 31

___310,000

Cost of goods manufactured

$13,610,000

2-20

Jackson Gears
Jackson Gears
Cost of Goods Sold Statement
For the Year Ending December 31,
200X
Beginning Finished Goods Inventory, Jan. 1

$420,000

Cost of goods manufactured

13,610,000

Finished goods available for sale

14,030,000

Less Ending Finished Goods Inventory, Dec. 31

Cost of goods sold

_930,000
$13,100,000

2-21

Jackson Gears
Jackson Gears
Income Statement
For the Year Ending December 31,
200X
Sales
Less cost of goods sold

$20,450,000
13,100,000

Gross Margin

7,350,000

Marketing and Administrative Expenses

3,850,000

Operating Profit

$3,500,000

Cost Behavior
L.O. 5 Define basic cost behaviors including fixed,
variable, semivariable, and step costs.

Cost
Behavior?
How
costs respond to a change in
activity level within the relevant
range.
range

Relevant
range?
Range
of activity where the
total fixed costs or the unit
variable costs remain
unchanged.

2-22

Fixed Costs
Costs that are unchanged as volume changes
within the relevant range of activity.

Fixed costs are fixed in total as activity changes.

On a per unit basis the cost varies inversely as
activity changes.

Cost
s ($)

Activity
level

2-23

Joshs Spring Break

Trip
Fixed Cost
Fixed costs are fixed in total as activity changes.
On a per unit basis the cost varies inversely as
activity changes.

Airfar
e cost
($)

Days on the
slopes

2-24

Variable
Costs that change in direct proportion with a
Costs
change in volume within the relevant range of
activity.

Variable costs vary in total as activity changes.

On a per unit basis the cost stays the same as activity
changes.

Cost
($)

Activity
level

2-25

2-26

Joshs Spring Break

Trip
Variable Cost
Variable costs vary in total as activity changes.
On a per unit basis the cost stays the same as activity
changes.

Lift
ticket
cost
($)
Days on the
slopes

Semivariable Costs
Costs that have both fixed and variable
components.
Also called mixed

costs.

Fixed component is fixed in total as activity changes.

Variable component varies in total as activity
changes.

Cost
s ($)

Activity

2-27

Joshs Spring Break

Trip Semivariable Cost
Fixed component is fixed in total as activity changes.
Variable component varies in total as activity changes.

Cos
t of
trip
($)

Days on the slopes

2-28

Step Costs
Costs that increase in total with steps in volume
changes.
Also called semifixed

costs.

Cost
s ($)

Activity
level

2-29

Product Cost
L.O. 6 Identify the components of a
Components
products costs.
Full cost: sum of all costs of
manufacturing and selling a unit of
product
Full absorption cost: sum of all variable
and fixed costs of manufacturing a unit of
product
Variable cost: sum of all variable costs of
manufacturing and selling a unit of
product

2-30

Costs: An Example
Direct Materials = $8
Direct Labor = $7
Variable manufacturing
overhead = $8
Fixed manufacturing
overhead = $6
Variable marketing and
administrative = $4
Fixed marketing and
administrative = $7

2-31

2-32

Full Cost
Direct Materials = $8
Direct Labor = $7

All costs of
manufacturing
and selling a unit
of product

Variable manufacturing
overhead = $8
Fixed manufacturing
overhead = $6
Variable marketing and
administrative = $4
Fixed marketing and
administrative = $7

Full Absorption Cost

Direct Materials = $8
Direct Labor = $7

All variable and

fixed costs of
manufacturing a
unit of product sold

Variable manufacturing
overhead = $8
Fixed manufacturing
overhead = $6

2-33

2-34

Variable Cost
Direct Materials = $8
Direct Labor = $7

All variable
costs of
manufacturing
and selling a
unit of product

Variable manufacturing
overhead = $8
Variable marketing and
administrative = $4

Making Cost Information

L.O. 7 Understand distinction between
Usefulfinancial and contribution margin
income statements.

Full Absorption
Costing
Required by
GAAP
Used
for:

Financial
purposes
External reporting

Variable
Costing
Used
for:

Managerial purposes
Internal decision
making

Sales revenues

Sales revenues

- Cost of goods
sold
= Gross margin

- Variable costs
= Contribution margin

2-35

Making Cost Information Useful

Continued
Financial
Income
Statement
Full Absorption
Costing
Gross margin
Sales price
Full absorption cost

2-36

Contribution
Margin Income
Statement
Variable Costing

Contribution margin
Sales price
Variable cost

Product vs Period
Costs
Full Absorption
Variable
Costing
Variable manufacturing
costs
Fixed manufacturing
costs

Variable marketing and

administrative costs

Fixed Marketing and

administrative costs

Costing
Variable

Produ
ct
costs

manufacturing costs

Fixed manufacturing
costs

Period
costs

Variable marketing and

administrative costs
Fixed Marketing and
administrative costs

2-37

Income
Statements
Full Absorption
Costing

2-38

Variable Costing

Sales revenues

Sales revenues

- Cost of goods
sold
= Gross
margin
- Marketing and
administrative
cost

- Variable costs

= Operating profit

Variable and fixed

manufacturing
costs
Sales Full
absorption cost

Full
absorption
costs
Period
costs

= Contribution
margin
- Fixed costs
= Operating profit

Variable
manufacturing
costs and variable
marketing and
administrative
costs

Sales variable
costs
Fixed manufacturing
costs and fixed
marketing and
administrative costs

2-39

Gross Margin per

Unit
Variable manufacturing
Full absorption
cost per unit =
$29

cost = $23

DM + DL +
VMOH

Fixed manufacturing
cost = $6

Full cost
per unit =
$40

Variable marketing and

administrative = $4

Gross margin =
$16 ($45 - $29)

Sales price
per unit =
$45

Fixed marketing and

administrative = $7

Excess of price over

full unit cost = $5

Operating
profit = $5

Contribution Margin per

Unit
Variable manufacturing
Variable cost per
unit =$27

cost = $23

2-40

DM + DL +
VMOH

Variable marketing and

administrative = $4

Full cost
per unit =
$40

Fixed manufacturing
cost = $6

Sales price
per unit
=$45

Fixed marketing and

administrative = $7
Contribution margin
=$18 ($45 - $27)

Excess of price over

full unit cost = $5

Operating
profit =$5

Chapter 2

2-41