CHAPTER 2

Basic Cost Management Concepts

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Describe a cost management information system, its objectives and major subsystems,
and indicate how it relates to other operating and information systems.
2. Explain the cost assignment process.
3. Define tangible and intangible products, and explain why there are different product cost
definitions.
4. Prepare income statements for manufacturing and service organizations.
5. Explain the differences between traditional and contemporary cost management systems.

CHAPTER SUMMARY
This chapter introduces a systems framework as a logical basis for the study of cost manage-
ment. The major objective of the cost accounting system is to assign costs to cost objects through
direct tracing, driver tracing, and allocation. Allocation is the least accurate and least desirable
approach, and thus, a cost accounting system should be designed to minimize allocations. Prod-
uct and service costs are introduced because they are important for external financial reporting.
Given the increasing magnitude of the service sector, you should pay attention to the types of
services, how they differ from tangible products, and the format for external income statements for
service firms. The chapter explains the differences between functional-based and activity-based
cost management systems.

CHAPTER REVIEW
This chapter introduces the fundamental cost concepts and the associated information systems that
produce the cost information.

I. A Systems Framework Learning Objective #1

A system is a set of interrelated parts that performs one or more processes to accom-
plish specific objectives.
A. Accounting Information Systems
An accounting information system is a system consisting of interrelated manual and
computer parts, using processes such as collecting, recording, summarizing, analyz-
ing, and managing data to provide output information to users.
1. An accounting information system (AIS) consists of the following:

15
16 Chapter 2

a. Objectives, which provide information to users.

b. Interrelated parts, which include subsystems such as order entry and sales,
billing accounts receivable and cash receipts, inventory, general ledger, and
cost accounting.
c. Processes, which include activities of collecting, recording, summarizing, ana-
lyzing, and managing data.
d. Outputs, which include data and reports that provide needed information for us-
ers.
2. An accounting information system has two distinguishing characteristics:
a. Inputs are usually economic events.
b. Accounting information system output is critically involved with the users of infor-
mation, since the output produces user actions:
 Serving as the basis for tactical and strategic decisions.
 Confirming that the actions taken had the intended effects.
 Providing feedback.
3. The accounting information system can be divided into two major subsystems: (a) the
financial accounting information system and (b) the cost management information
system.
a. Financial Accounting Information System
 The financial accounting information system is primarily concerned
with producing outputs for external users (investors, creditors, government
agencies, and other outside users).
 The financial accounting information system uses well-specified economic
events as inputs.
 The nature of the inputs and the rules and conventions governing process-
es are defined by the SEC and the FASB.
 The overall objective is to prepare financial statements such as the balance
sheet, income statement, and statement of cash flows for external users.
These are used for investment decisions, stewardship evaluation, monitor-
ing activity, and regulatory measures.
b. Cost Management Information System
 The cost management information system is primarily concerned with
producing outputs for internal users.
 The cost management information system uses inputs and processes to
satisfy management objectives. A cost management information system is
not bound by any formal criterion that defines inputs or processes.
 A cost management information system has three broad objectives:
(1) To provide information for costing out services, products, and other ob-
jects of interest to management.
(2) To provide information for planning and control.
(3) To provide information for decision making.
Basic Cost Management Concepts 17

B. Relationship to Other Operational Systems and Functions

A cost management information system should be integrated with the organiza-
tion’s operational systems because of the current competitive environment.

Review textbook Exhibit 2-3, which illustrates

an integrated cost management system.

C. Integrated Information Systems

Enterprise Resource Planning (ERP) systems are computerized information systems
that keep track of data across the company. A well-designed ERP system will:
1. Strive to input data once and reduce data errors.
2. Store the data in a single integrated database and make it available instantaneous-
ly to people across the company for whatever purposes it may serve.
3. Include both financial and nonfinancial data, allowing greater control through the
generation of operational measures of achievement.
4. Generate different reports for different purposes (e.g., financial statements, man-
agement reports, and sales forecasts).
D. Different Systems for Different Purposes
Different systems satisfy different purposes. The cost management information system
has two subsystems: the cost accounting information system and the operational control
information system.
1. Cost Accounting Information System
The cost accounting information system is a cost management subsystem de-
signed to assign costs to individual products and services and other objects as
specified by management.
a. For external financial reporting, the cost accounting system must:
 Assign costs to products in order to value inventories and determine cost of
sales.
 Conform to SEC and FASB rules and conventions.
The rules require that inventory values and cost of sales reported in the ag-
gregate on the financial statements be reasonably accurate. At the individu-
al product level, however, product costs may be distorted because costs
assigned to individual products are not causally related to the demands of
the product.
b. For internal decision making, accurate product costs are needed. The cost
accounting information system may need to produce two sets of product costs:
 One that satisfies financial reporting criteria.
 Another that satisfies management decision-making needs.
2. Operational Control Information System
The operational control information system is a cost management subsystem
designed to provide accurate and timely feedback concerning the performance of
managers and others relative to their planning and control of activities.
18 Chapter 2

Operational control is concerned with what activities should be performed and as-
sessing how well they are performed. The operational control information system
must:
 Provide information that helps managers engage in a program of continu-
ous improvement of all aspects of their businesses.
 Provide broad information that encompasses the entire value chain to improve
the value received by customers.
 Provide cost information concerning quality, different product designs, and
post-purchase customer needs.

Review textbook Exhibit 2-4, which illustrates the various

subsystems of the accounting information system.

II. Cost Assignment: Direct Tracing, Driv-

Learning Objective #2
er Tracing, and Allocation
Terms used to describe the cost assignment process are defined as follows:
 Cost is the cash or cash equivalent value sacrificed for goods and services that are ex-
pected to bring a current or future benefit to the organization.
 Expenses are the expired costs that have been used up in the production of revenues.
 A loss is a cost that expires without producing any revenue benefit.
 Assets are the costs that do not expire in a given period; they are reported on the
balance sheet.
Note that expenses and losses are expired costs and are reported on the income state-
ment.
A. Cost Objects
1. Cost objects are items that are used in management accounting systems to mea-
sure and assign costs.
2. Common cost objects include products, customers, departments, projects, and
activities.
3. An activity is a basic unit of work performed within an organization. An activity can
also be defined as an aggregation of actions within an organization useful to man-
agers for purposes of planning, controlling, and decision making.
4. Activities have emerged as important cost objects.
B. Accuracy of Assignments
1. The objective of cost assignment is to measure and assign accurately the cost of
the resources used by a cost object.
2. The accuracy of cost assignment depends on traceability, which is the ability to
assign a cost directly to a cost object in an economically feasible way by means of
a causal relationship. The more costs that can be traced to the object, the great-
er the accuracy of the cost assignments.
3. There are two methods of tracing costs to cost objects:
Basic Cost Management Concepts 19

a. Direct tracing is the process of identifying and assigning costs to a cost object
that are specifically or physically associated with the cost object.
(1) Direct costs are costs that can be traced easily and accurately to a
cost object.
(2) Indirect costs are costs that cannot be traced easily and accurately to
a cost object.
b. Driver tracing is the use of drivers to assign costs to cost objects.
Drivers are the cause-and-effect factors that can be used to measure a cost ob-
ject’s resource consumption. Drivers are factors that cause changes in resource
usage, activity usage, costs, and revenues.
4. Allocation is the assignment of indirect costs to cost objects.
a. Allocation is based on convenience or some assumed linkage because no causal
relationship exists between the cost and the cost object or the tracing is not
economically feasible.
b. Arbitrary allocation of indirect costs reduces the overall accuracy of cost
assignments.
5. The following is a summary and comparison of the cost assignment methods:
 Direct tracing is the most precise method.
 The accuracy of driver tracing depends on the quality of the causal relationship
described by the driver.
 Allocation is the least precise method. It is simple and has a low cost of
implementation.

Review textbook Exhibit 2-5, which summarizes the methods

of assigning costs to cost objects.

III. Product and Service Costs

Learning Objective #3

The output of an organization (product and/or service) represents one of the most important
cost objects. There are two types of output:
 Tangible products are goods that are produced by converting raw materials through
the use of labor and capital inputs.
 Services are tasks or activities performed for a customer or an activity performed by a
customer using an organization’s products or facilities.
 Services are intangible products because buyers of services cannot see, feel, hear,
or taste a service before it is bought (intangibility).
 Services are perishable because they cannot be stored (perishability).
 Services are inseparable from their producers because producers and buyers must
usually be in direct contact for an exchange to take place (inseparability).
A. Different Costs for Different Purposes
Product cost definitions can differ according to the managerial objective being served.
20 Chapter 2

1. All traceable costs in the value chain need to be assigned to the product for long-
term decisions such as pricing, product mix, and strategic profitability analysis.
2. The production, marketing, and customer service costs (including customer post-
purchase costs) are assigned to the product for strategic product design decisions
and tactical profitability analysis.
3. Only production costs are used in calculating product costs for external financial
reporting.

Review textbook Exhibit 2-6, which provides three examples of

product cost definitions and some of the objectives they satisfy.

B. Product Costs and External Financial Reporting

For external financial reporting, costs are subdivided into two functional classifications:
 Production costs are those costs associated with the manufacture of goods or the
provision of services.
 Nonproduction costs are those costs associated with the functions of selling
and administration.
1. Production costs in a manufacturing firm can be further classified as follows:
a. Direct materials are those materials that are traceable to the good or service
being produced.
b. Direct labor is the labor that is traceable to the goods or services being pro-
duced.
c. Overhead includes all production costs other than direct materials or direct labor.
Examples of overhead costs include:
 Those supplies that are necessary for production but that do not become
part of the finished product.
 Materials that are insignificant.
 An overtime premium that is common to all production runs.
2. Nonproduction costs are categorized as follows:
a. Marketing (selling) costs are the costs necessary to market and distribute a
product or service. They are often referred to as order-getting and order-filling
costs.
b. Administrative costs are all costs associated with the general administration
of the organization that cannot be reasonably assigned to either marketing or
production.
Note the following:
 Marketing and administrative costs are period (noninventoriable) costs.
None of these costs are assigned to products because they relate to nonmanu-
facturing activities.
 Marketing and administrative costs are period costs that are expensed in the
period in which they are incurred.
Basic Cost Management Concepts 21

3. Other related cost terms include the following:

a. Prime cost is the sum of direct materials cost and direct labor cost.
b. Conversion cost is the sum of direct labor cost and overhead cost. For a
manufacturing firm, conversion cost can represent the cost of converting raw
materials into a final product.

Review textbook Exhibit 2-7, which illustrates the

various types of production and nonproduction costs.

IV. External Financial Statements Learning Objective #4

The functional classification is the cost classification required for external reporting.
A. Income Statement: Manufacturing Firm
1. The income statement of a manufacturing firm reports absorption-costing in-
come or full-costing income in which:
a. All manufacturing costs are fully assigned to the product.
b. Income is computed by following a functional classification of the two major
categories of expenses:
 Cost of goods sold is the cost of direct materials, direct labor, and over-
head attached to units sold.
 Operating expenses.

Review textbook Exhibit 2-8, which shows an income statement

based on a functional classification for a manufacturing firm.

2. Supporting Schedules for the Income Statement

a. A statement of cost of goods manufactured:
 Reports the total manufacturing cost of goods completed during the cur-
rent period.
 Includes only the manufacturing costs of direct materials, direct labor, and
overhead.
 Involves the work-in-process inventory computation. Work in process
consists of all partially completed units found in production at any point in
time.
BI (WIP) + Added manufacturing costs = Cost of goods manufactured + EI (WIP)
where BI (WIP) = Costs of beginning inventory work in process
EI (WIP) = Costs of ending inventory work in process
22 Chapter 2

Review textbook Exhibit 2-9, which shows a statement of cost of goods manufactured.

b. A statement of cost of goods sold:

 Reports the manufacturing cost of units that were sold during the period.
 Involves the finished goods inventory computation.
BI (FG) + Cost of goods manufactured = Cost of goods sold + EI (FG)
where BI (FG) = Costs of beginning inventory finished goods
EI (FG) = Costs of ending inventory finished goods

Review textbook Exhibit 2-10, which shows a cost of

goods sold schedule for a manufacturing firm.

B. Income Statement: Service Organization

1. The income statement for a service organization reports cost of services sold.
2. The service firm has no finished goods inventory because services cannot be stored.
3. The income statement involves the work-in-process inventory computation. Work in
process consists of all partially completed projects found at any point in time.
BI (WIP) + Added service costs = Cost of services sold + EI (WIP)
where BI (WIP) = Costs of beginning inventory work in process
EI (WIP) = Costs of ending inventory work in process

V. Functional-Based and Activity-Based Learning Objective #5

Cost Management Systems
Cost management systems can be broadly classified as functional-based and activity-based.
Both systems are found in practice because different systems meet the needs of different
companies. The differences between the two cost management systems are as follows.
A. Functional-Based Cost Management Systems
A functional-based cost management system is made up of two subsystems:
1. A functional-based cost accounting system (functional-based cost system):
a. Assumes that all costs can be classified as fixed or variable with respect to
changes in the units or volume of product produced.
b. Uses primarily unit- or volume-based cost drivers to assign costs to cost ob-
jects.
c. Tends to be allocation-intensive because much of the product cost assignment
is based on assumed linkages or convenience.
d. Meets the financial reporting objectives of assigning production costs to inven-
tories and cost of goods sold.
2. A functional-based operation control system:
a. Assigns costs to units and then holds the unit manager responsible for control-
ling the assigned costs.
Basic Cost Management Concepts 23

b. Rewards individuals based on their ability to control costs.

c. Emphasizes financial measure performance by comparing actual outcomes
with standard (budgeted) outcomes.
d. Assumes that the performance of the overall organization is achieved by max-
imizing the performance of individual organizational subunits.
B. Activity-Based Cost Management Systems
The overall objective of an activity-based cost management system is to improve the
quality, content, relevance, and timing of cost information.
1. An activity-based cost accounting system [activity-based cost (ABC) system]:
a. Emphasizes tracing over allocation by identifying drivers unrelated to the volume
of product produced.
b. Improves the accuracy of cost assignments by using both unit- and nonunit-
based activity drivers.
c. Improves the overall quality and relevance of cost information by producing
cost information for a variety of managerial objectives.
2. An activity-based operation control system [activity-based management (ABM)]:
a. Focuses on the management of activities with the objective of improving the val-
ue received by the customer and the profit received by the company in provid-
ing this value.
b. Refers to the process view of the ABM model, identifying factors that cause an
activity’s cost, assessing what work is done, and evaluating the work performed
and the results achieved.
c. Focuses on accountability for activities rather than costs.
d. Emphasizes the maximization of systemwide performance instead of individual
performance.
e. Uses both financial and nonfinancial performance measures.

Review textbook Exhibit 2-11, which presents the activity-based management model.

In conclusion, the advantages of an activity-based cost management system include:

 Greater product-costing accuracy.
 Improved decision making.
 Enhanced strategic planning.
 Better ability to manage activities.

Review textbook Exhibit 2-12, which compares the characteristics of the

functional-based and activity-based cost management systems.

C. Choice of a Cost Management System

1. The optimal cost management system is the one that minimizes the sum of measure-
ment costs and error costs.
24 Chapter 2

a. Measurement costs are the costs associated with the measurements required
by the cost management system.
b. Error costs are the costs associated with making poor decisions based on inac-
curate product costs or bad cost information.

Review textbook Exhibit 2-13, which graphically illustrates

the trade-off between measurement and error costs.

2. Recent changes in the manufacturing environment have changed the trade-off

between measurement costs and error costs because:
a. New information technology decreases measurement costs.
b. Changes in the nature of the competition increases error costs.
c. Deregulation and JIT manufacturing increase the cost of errors.
d. Ethical misconduct increases the cost of errors.
The net result is a decrease in measurement costs and an increase in error costs.
Therefore, a more accurate cost management system is mandated because of
changes in error and measurement costs.

Review textbook Exhibit 2-14, which graphically illustrates shifting

costs and justification for a more accurate costing system.
Basic Cost Management Concepts 25

KEY TERMS TEST

SET #1
From the list that follows, select the term that best completes each statement and write it in the
space provided.

accounting information system functional-based operation control system

activity-based costing intangibility
activity-based management (ABM) measurement costs
cost accounting information system nonproduction costs
cost management information system operational control information system
error costs production (or product) costs
financial accounting information system system
functional-based cost system

1. The costs associated with the measurements required by the cost management system are
the ______________________________.

2. The _________________________________________________________ is designed to

assign costs to individual products and services.

3. ____________________________________ uses both unit- and nonunit-based activity

drivers to assign costs to cost objects.

4. A cost accounting system that uses only unit-based activity drivers to assign costs to cost
objects is considered a(n) _______________________________________________.

5. A(n) _________________________________________________ consists of interrelated

manual and computer parts, using processes such as collecting, recording, summarizing,
analyzing, and managing data to provide output information to users.

6. ____________________________ are associated with the manufacture of goods or the pro-

vision of services.

7. A(n) _________________________________________________________ assigns costs to

organizational units and then holds the manager responsible for controlling the costs.

8. The ___________________________________________________________ is concerned

with producing outputs for internal users; the _______________________________
_________________________________________ is concerned with producing outputs for
external users.

9. The activity-based control system known as _______________________________

___________ includes driver analysis, activity analysis, and performance evaluation.

10. Costs associated with the functions of selling and administration are ________________
_____________________.
26 Chapter 2

11. A(n) ____________ is a set of interrelated parts that performs one or more processes to
accomplish specific objectives.

12. __________ means that buyers of services cannot see, feel, hear, or taste a service before it
is bought because services are intangible products.

13. The _______________________________________________________________ is de-

signed to provide accurate and timely feedback concerning the performance of managers
relative to their planning and control of activities.

14. The costs associated with making poor decisions based on inaccurate product costs are the
__________________.

SET #2
From the list that follows, select the term that best completes each statement and write it in the
space provided.

absorption-costing income inseparability

activity period costs
cost object perishability
direct costs resource drivers
direct tracing service
driver tracing tangible products
drivers traceability
indirect costs work in process

1. ____________________________ consists of all partially completed units found in produc-

tion at a given time.

2. Any item for which costs are measured and assigned is a(n) __________________.

3. A task or activity performed for a customer is a(n) ____________.

4. __________________________________________ is income computed following a func-

tional classification.

5. Factors that cause changes in resource usage, activity usage, costs, and revenues are
____________; the use of these to assign costs to cost objects is called ___________
___________.

6. Goods that are produced by converting raw materials by using labor and capital are
____________________________.

7. ________________________ cannot be traced to a cost object.

8. ________________________ is the process of identifying costs that are specifically or physi-

cally associated with a cost object.

9. __________ means that services are perishable because they cannot be stored.
Basic Cost Management Concepts 27

10. The basic unit of work performed within an organization is a(n) ______________.

11. ______________________ can be easily and accurately traced to a cost object.

12. The ability to economically assign a cost directly to a cost object using a causal relationship
is known as __________________.

13. __________ means that services are inseparable from their producers because producers and
buyers must usually be in direct contact for an exchange to take place.

14. Marketing and administrative costs are _______________ that are expensed in the period in
which they are incurred.

SET #3
From the list that follows, select the term that best completes each statement and write it in the
space provided.

administrative costs direct materials

allocation expenses
assets full-costing income
conversion cost loss
cost marketing costs
cost of goods manufactured overhead
cost of goods sold prime cost
direct labor supplies

1. _________ is the cash or cash equivalent value sacrificed for goods or services that are
expected to bring a current or future benefit to the organization.

2. The costs that cannot be reasonably assigned to either marketing or production are the
________________________________.

3. ____________________________ are materials that are traceable to the goods or services

being produced.

4. All production costs other than direct materials and direct labor are included in
_______________.

5. The sum of direct labor cost and overhead cost is called _________________________; the
sum of direct materials cost and direct labor cost is called _________________________.

6. Materials necessary for production but which do not become part of the finished product are
______________.

7. The total cost of goods completed during the current period is the ______________________
_______________________; the total cost assigned to goods sold during the period is the
_____________________________________________.
28 Chapter 2

8. Those costs necessary to market and distribute a product or service are the
__________________________.

9. The assignment of indirect costs to cost objects is called _________________.

10. _____________________ is labor that is traceable to the goods or services being produced.

11. Expired costs are _______________.

MULTIPLE-CHOICE QUIZ
Complete each of the following statements by circling the letter of the best answer.

1. The assignment of indirect costs to cost objects is called:

a. activity-based costing.
b. allocation.
c. driver tracing.
d. mixed costs.
e. variable costs.

2. Direct tracing is:

a. assigning indirect costs to cost objects.
b. identifying cost objects attributed to activity drivers.
c. assigning costs to cost objects using drivers.
d. identifying costs that are specifically or physically associated with a cost object.
e. identifying factors that cause costs to change.

3. Which of the following is not a method of assigning costs to cost objects?

a. allocation
b. conversion costing
c. direct tracing
d. driver tracing
e. All of the above are methods for assigning costs to cost objects.

4. The accounting information subsystem that is primarily concerned with producing outputs for
external users is:
a. the cost accounting information system.
b. the cost management information system.
c. the financial accounting information system.
d. the operational control information system.
e. none of the above.
Basic Cost Management Concepts 29

5. The cost management system should not be integrated with which of the following?
a. customer servicing system
b. design and development system
c. marketing and distribution system
d. production system
e. The cost management system should be integrated with all of the above systems.

6. The cost management subsystem that is designed to provide accurate and timely feedback
concerning the performance of managers relative to their planning and control of activities is:
a. the activity-based costing information system.
b. the cost accounting information system.
c. the financial accounting information system.
d. the operational control information system.
e. none of the above.

7. Expired costs are:

a. assets.
b. expenses.
c. liabilities.
d. losses.
e. revenues.

8. Which of the following methods of tracing costs will yield the most precision?
a. allocation
b. direct tracing
c. driver tracing
d. indirect costing
e. none of the above

9. Product costs used for external financial reporting will include which of the following?
a. customer service costs
b. marketing costs
c. production costs
d. research and development costs
e. all of the above

10. The optimal cost management system is the one that:

a. minimizes the error costs.
b. minimizes the measurement costs.
c. minimizes the sum of the error costs and the measurement costs.
d. costs the least to operate.
e. uses contemporary cost management principles.
30 Chapter 2

11. Which of the following statements is true?

a. The optimal cost management system will never be a traditional system.
b. A multiproduct firm will have more accurate product costs because there are more products
over which to spread the costs.
c. The costs of measurement have been increasing as new information technology is used.
d. The use of direct tracing rather than allocation should cause the cost of errors to decrease.
e. As costs of measurement increase, a more accurate cost system will become optimal.

Use the following information for Questions 12 through 14:

Sawmill Corp. started December with 500 units in beginning finished goods. During the
month, 4,000 units were produced, and 3,700 units were sold. Costs added during December
were direct materials, $2,000; direct labor, $400; and production overhead, $1,400. Sales salaries
totaled $1,200; administrative costs totaled $800. Inventory balances were as follows:
Beginning work in process ............... $250
Beginning finished goods ................. 450
Ending work in process .................... 600
Ending finished goods...................... 690

12. What is the cost of goods manufactured?

a. $3,210
b. $3,450
c. $3,800
d. $5,450
e. $5,800

13. What is the cost of goods sold?

a. $3,210
b. $3,450
c. $3,800
d. $5,450
e. $5,800

14. If each unit sold for $2.00, what would the absorption costing profit be?
a. $1,600
b. $1,950
c. $2,190
d. $2,590
e. none of the above
Basic Cost Management Concepts 31

PRACTICE TEST

EXERCISE 1
Required:
Describe three ways that functional cost accounting differs from activity-based cost accounting.
32 Chapter 2

EXERCISE 2
Darwin Company manufactured 30,000 widgets last year while selling 29,000 units for $15 each.
The actual production costs (on a per-unit basis) for the widgets were as follows:
Direct materials ............................ $3.50
Direct labor ................................... 1.25
Variable overhead ........................ 0.75
Fixed overhead ............................ 3.75
Total unit cost ............................... $9.25

Selling costs included a commission of $1 per unit sold and advertising of $50,000. Administrative
expenses, all fixed, totaled $35,000. There were no work-in-process inventories. There was
no beginning finished goods inventory.

Required:
Prepare an absorption-costing income statement.
Basic Cost Management Concepts 33

EXERCISE 3
ABB Company manufactures paperweights. During May, direct labor cost was $35,400, raw mate-
rials of $66,000 were purchased, and overhead totaled $59,000. The following information has been
obtained from the inventory reports:
May 1 May 31
Raw materials inventory........................... $3,500 $4,700
Work-in-process inventory ....................... 2,600 4,100
Finished goods inventory ......................... 9,800 8,700

Required:
1. Prepare a cost of goods manufactured statement for May.

2. Prepare a cost of goods sold statement for May.

34 Chapter 2

EXERCISE 4
Southport Architects provides architectural services for real estate developers. During Octo-
ber, Southport completed and invoiced contracts totaling $215,000.
At the beginning of October there were 10 jobs in progress, with accumulated costs of $34,000.
Materials and supplies totaling $23,000 were used during the month, architect salaries of $75,000
were paid, and overhead was estimated to be $56,000.
There were 5 unfinished jobs at the end of October with accumulated costs of $21,500. Adminis-
trative salaries were $26,000, and related administrative overhead was estimated to be $15,000.

Required:
Prepare an income statement for the month of October for Southport Architects.
Basic Cost Management Concepts 35

“CAN YOU?” CHECKLIST

 Can you identify the characteristics of an information system, explain what makes an account-
ing information system different from other information systems, and explain the distinctions
among the following subsystems of the accounting information system?
 cost accounting information system
 cost management information system
 financial accounting information system
 operational control information system
 Can you describe the cost assignment process and explain when direct tracing, driver tracing,
and allocation would be used? Can you explain under what conditions each of these ap-
proaches will give more accurate product costs?
 Can you describe the difference between an activity driver and a resource driver? Can you
explain what each one measures?
 Can you describe the difference between a tangible product and a service? Can you prepare
an income statement for each?
 Can you differentiate between the cost of goods manufactured and the cost of goods sold for
a manufacturing company? for a service company? Can you prepare the required statements?
 Can you describe the connection between activity drivers and cost behavior?
 Can you explain the differences between traditional and contemporary cost accounting sys-
tems? between traditional and contemporary operational control systems?

ANSWERS

KEY TERMS TEST

SET #1
1. measurement costs 9. activity-based management
2. cost accounting information system 10. nonproduction costs
3. Activity-based costing 11. system
4. functional-based cost system 12. Intangibility
5. accounting information system 13. operational control information system
6. Production (or product) costs 14. error costs
7. functional-based operation control system
8. cost management information system, financial
accounting information system
36 Chapter 2

SET #2
1. Work in process 8. Direct tracing
2. cost object 9. Perishability
3. service 10. activity
4. Absorption-costing income 11. Direct costs
5. drivers, driver tracing 12. traceability
6. tangible products 13. Inseparability
7. Indirect costs 14. Period costs

SET #3
1. Cost 7. cost of goods manufactured, cost of goods sold
2. administrative costs 8. marketing costs
3. Direct materials 9. allocation
4. overhead 10. Direct labor
5. conversion cost, prime cost 11. expenses
6. supplies

MULTIPLE-CHOICE QUIZ
1. b 5. e 9. c
2. d 6. d 10. c
3. b 7. b 11. d
4. c 8. b

12. b Cost of goods manufactured + EI (WIP) = BI (WIP) + Added manufacturing costs

Cost of goods manufactured = BI (WIP) + Added manufacturing costs – EI (WIP)
Cost of goods manufactured = BI (WIP) + (Direct materials + Direct labor + Production overhead) – EI (WIP)
Cost of goods manufactured = $250 + ($2,000 + $400 + $1,400) – $600 = $3,450
13. a Cost of goods sold + EI (FG) = BI (FG) + Cost of goods manufactured
Cost of goods sold = BI (FG) + Cost of goods manufactured – EI (FG)
Cost of goods sold = $450 + $3,450 – $690 = $3,210
14. c Revenues (3,700 units sold × $2.00) .......................................... $7,400
Less cost of goods sold................................................................ 3,210
Gross margin ................................................................................ $4,190
Less selling and administrative expenses ($1,200 + $800)......... 2,000
Net income ................................................................................... $2,190

PRACTICE TEST
EXERCISE 1 (Comparisons between Functional-Based and Activity-Based Cost Accounting)
1. The functional-based cost accounting systems use only unit-based activity drivers to assign costs to cost objects.
The activity-based cost accounting systems use both unit- and nonunit-based activity drivers.
2. The functional-based cost accounting systems tend to be allocation-intensive. The activity-based cost account-
ing systems more often use direct tracing and driver tracing.
3. The functional-based cost systems tend to use an external financial reporting definition of product cost as the cost
object. Thus, costs are divided into product (inventoriable) and period (noninventoriable) costs. The activity-based
cost systems use a variety of cost objects, depending upon the decision being made. The cost objective may be the
value-chain product cost or the operating product cost.
Basic Cost Management Concepts 37

EXERCISE 2 (Absorption-Costing Income Statement)

Darwin Company
Income Statement
For the Year Ended 2004
Sales (29,000 × $15) .......................................................................... $435,000
Cost of goods sold:
Beginning finished goods inventory................................................. $ 0
Add: Cost of goods manufactured (30,000 × $9.25) ..................... 277,500
Goods available for sale .................................................................. $ 277,500
Less: Ending finished goods inventory (1,000 × $9.25) ................ 9,250 268,250
Gross margin ....................................................................................... $166,750
Less operating expenses:
Selling expenses [$50,000 + (29,000 × $1)]................................... $ 79,000
Administrative expenses ................................................................. 35,000 114,000
Operating income................................................................................. $ 52,750

EXERCISE 3 (Cost of Goods Manufactured and Sold Statements)

1. ABB Company
Statement of Cost of Goods Manufactured
For the Month Ended May 31, 2004
Direct materials:
Beginning inventory ......................................................................... $ 3,500
Add: Purchases .............................................................................. 66,000
Materials available........................................................................... $69,500
Less: Ending inventory ................................................................... 4,700
Direct materials used in production ................................................. $ 64,800)
Direct labor........................................................................................... 35,400)
Manufacturing overhead ...................................................................... 59,000)
Total manufacturing costs .................................................................... $159,200)
Add: Beginning work in process .......................................................... 2,600)
Less: Ending work in process ............................................................. (4,100)
Cost of goods manufactured ................................................................ $157,700)
2. ABB Company
Statement of Cost of Goods Sold
For the Month Ended May 31, 2004
Cost of goods manufactured ................................................................ $157,700
Add: Beginning inventory finished goods ............................................ 9,800
Cost of goods available for sale ........................................................... $167,500
Less: Ending inventory finished goods ............................................... 8,700
Cost of goods sold ............................................................................... $158,800

EXERCISE 4 (Income Statement: Service Organization)

Southport Architects
Income Statement
For the Month Ended October 31, 2004
Sales ................................................................................................... $215,000
Cost of services provided:
Materials and supplies .................................................................... $ 23,000
Architect salaries ............................................................................. 75,000
Overhead ........................................................................................ 56,000
Total costs added ............................................................................ $154,000
Add: Beginning work in process ..................................................... 34,000
Total ................................................................................................ $188,000
Less: Ending work in process ........................................................ 21,500
Total cost of services provided........................................................ 166,500
Gross margin ....................................................................................... $ 48,500
Operating expenses:
Administrative salaries .................................................................... $ 26,000
Administrative overhead .................................................................. 15,000
Total operating expenses ................................................................ 41,000
Operating income................................................................................. $ 7,500