Horngren’s Cost Accounting: A Managerial
Emphasis
Ninth Canadian Edition
Chapter 2
An Introduction to Cost
Terms and Purposes
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Learning Objectives (1 of 2)
1. Identify and distinguish between two
manufacturing cost classification systems (direct
and indirect, prime and conversion).
2. Differentiate fixed from variable cost behaviour
and explain the relationship of cost behaviour to
direct and indirect cost classifications.
3. Interpret unitized fixed costs appropriately when
making cost management decisions.
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Learning Objectives (2 of 2)
4. Apply cost information to produce an
IFRS/ASPE-compliant statement of
comprehensive income showing proper cost of
goods sold and a statement of financial position
showing proper inventory valuation.
5. Explain cost identification, classification, and
management systems and their use within the
decision framework.
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Basic Cost Terminology (1 of 2)
• Cost
– A resource sacrificed or foregone to achieve a specific
objective usually measured as a monetary amount paid
– To answer the question “What does it cost?” requires
knowing what “it” is and what problem the cost
information will be applied to
• Cost Object
– Any “object” such as a product, machine, service, or
process for which cost information is accumulated
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Basic Cost Terminology (2 of 2)
• Cost Accumulation
– Collection of cost data in an organized way
– Management Accountants refer to accumulated costs
as Cost Pools
• Cost Assignment
– Systematically links an actual cost pool to a distinct
cost object
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Direct and Indirect Costs
• Direct Costs
– Can be traced to a cost object in a cost-effective way,
using manual or electronic documentation
– Example: cost of tires in the manufacture of an
automobile
• Indirect Costs
– Cannot be traced to a cost object in a cost-effective
way because the benefits from the use of the
resources are shared among diverse cost objects
– Example: cost of electricity to run the factory
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Direct Cost Examples
• Direct Material costs (DM)
– Acquisition costs of all materials that become part of
the cost object and can be traced to the cost object in
an economically feasible way
– Example: raw materials, parts, freight-in, sales taxes,
customs duties
• Direct Manufacturing Labour costs (DML)
– Compensation of manufacturing labour that can be
traced to a cost object in an economically feasible way
– Example: wages of assembly line workers
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Indirect Cost Examples
• Indirect manufacturing costs (MOH)
– Manufacturing costs related to the cost object that
cannot be traced to the cost object in an economically
feasible way
– Allocated to cost objects
– Example: depreciation, maintenance supplies,
supervisor’s salaries
– Also referred to as manufacturing overhead costs or
factory overhead costs
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Prime and Conversion Costs
• Prime Costs
– Direct manufacturing costs
• Conversion costs
– All manufacturing costs other than DM required to
covert DM to finished goods
Prime costs DM DML
Conversion costs DML MOH
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Fixed and Variable Costs
• Variable costs (VC)
– Change in total in proportion to changes in output
within a relevant range (cost per unit is constant)
– Constant on a per unit basis
• Fixed costs (FC)
– Constant in total within a relevant range of output
– Change on a per unit basis as level of activity or
volume changes
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Cost Behaviour Summarized
Blank Total Dollars Cost per Unit
Change in proportion
Variable with output Unchanged in
Costs More output = More relation to output
cost
Change inversely
Fixed with output
Unchanged in
Costs More output =
relation to output
lower cost per
unit
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Cost Behaviour Visualized
Exhibit 2.3-4 Cost Behaviour of Monthly Fixed Costs, Cost Behaviour of Monthly Mixed Costs
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Multiple Classification of Costs Visualized
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Total Costs and Unit Costs
• Decision makers should think in terms of relevant
costs (rather than unit costs).
– The higher the quantity produced by a capital asset (a
FC) the lower the average FC per unit
– However total fixed cost (FC) is constant
• As a general rule, first calculate total costs, then
calculate a unit cost (if it is needed for a particular
decision).
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Period and Inventoriable Costs
• Period Costs
– Little evidence of future benefit (not considered an
asset), therefore expensed in the period incurred
– Are all the costs on the Statement of Comprehensive
Income other than cost of goods sold
• Inventoriable (Product) Costs
– All costs of a product that are considered an asset
when they are incurred
– Become cost of goods sold on the Statement of
Comprehensive Income when the product is sold
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Costs in a Manufacturing Company
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The Flow of Inventoriable Costs
• 4 Steps of create a Statement of Comprehensive
Income for a manufacturing company:
1. Cost of direct materials used
2. Total manufacturing costs incurred
3. Cost of Goods Manufactured
4. Cost of Goods Sold
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Cost of Goods Manufactured
Exhibit 2-8 Tech1 Statement of Comprehensive Income
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Multiple-Step Income Statement
Exhibit 2-8 Tech1 Statement of Comprehensive Income (continued)
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Measuring and Classifying Costs Requires
Judgement
• Definition and classification of costs depends on
the decision, the cost object and the company
• Measuring Labour Costs
– Direct manufacturing labour costs can be traced to
individual products
– Many ways to classify indirect labour (factory office
staff, factory security, rework, overtime, idle time,
manager’s salary, health care)
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Overtime Premiums and Idle Time
• Usually considered indirect costs or overhead
costs (they are not related to a particular product)
– Overtime Premiums are the wage rate paid in excess
of the straight wage rates
– Idle Time is the wages paid for unproductive time
caused by lack of orders, machine or computer
breakdowns, poor scheduling, etc.
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Decision Framework and Flexibility of
Costing Methods
• Different decisions often require different
measures of product cost
• Use the 5-step decision-making process to
classify costs depending on the decision:
1. Identify the problem
2. Obtain information
3. Predict the future
4. Decide among alternatives
5. Implement decision, evaluate performance, learn
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Different Costs for Different Purposes
• A product cost is the sum of costs assigned to a
product for a specific purpose, such as:
– To identify and manage cost-control problems
– For product pricing and product emphasis
– For contracting with government agencies
– For Financial Statements
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Different Product Costs for Different
Purposes
Exhibit 2-10 Different Product Costs for Different Purposes
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Different Cost Classification Systems
1. Business function 3. Behaviour pattern in
a. Research and development relation to the level of
b. Design of products, activity or volume
services, or processes a. Variable cost
c. Production b. Fixed costs
d. Marketing
4. Aggregate or average
e. Distribution
a. Total cost
f. Customer service
b. Unit cost
2. Assignment to a cost
object 5. Assets or expenses
a. Inventoriable (product) cost
a. Direct cost
b. Period cost
b. Indirect cost
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