An Introduction to Cost Terms and Purposes

© 2009 Pearson Prentice Hall. All rights reserved.

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

© 2009 Pearson Prentice Hall. All rights reserved.

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.

© 2009 Pearson Prentice Hall. All rights reserved.

Relevant Range Visualized

© 2009 Pearson Prentice Hall. All rights reserved.

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

© 2009 Pearson Prentice Hall. All rights reserved.

Costs Classified as to Relation to a
Product
. Manufacturing Costs / Product Costs
These are costs directly involved in the production of
goods.
Direct Materials – Raw materials that become an
integral part of the finished product.
Example: Steel for car manufacturing.
Direct Labor – Wages of workers directly involved in
production.
Example: Assembly line workers' wages.
Factory Overhead – Indirect costs in production.
Example: Factory rent, utilities, depreciation of
machinery.
© 2009 Pearson Prentice Hall. All rights reserved.
Non-Manufacturing Costs / Period
Costs
These are costs not directly related to
manufacturing and are expensed in the period
they occur.
Marketing or Selling Expense – Costs to
promote and sell products.
Example: Advertising costs, sales commissions.
General or Administrative Expense –
Costs of overall business operations.
Example: Office rent, executive salaries.

© 2009 Pearson Prentice Hall. All rights reserved.

Costs Classified as to Relation to
Manufacturing Departments
Direct Departmental Charges – Costs
directly traceable to a department.
Example: Wages of machine operators in a
specific department.
Indirect Departmental Charges – Costs
not directly traceable to one department.
Example: Factory security expenses.

© 2009 Pearson Prentice Hall. All rights reserved.

Costs Classified to Their Nature as
Common or Joint

Common Costs – Costs benefiting multiple

departments or products.
Example: Factory supervisor's salary.
Joint Costs – Costs of producing multiple
products simultaneously up to a split-off point.
Example: Crude oil refining into gasoline,
diesel, and kerosene.

© 2009 Pearson Prentice Hall. All rights reserved.

Costs Classified as to Relation to an
Accounting Period
Capital Expenditures – Costs incurred to
acquire or improve long-term assets.
Example: Purchase of factory machinery.
Revenue Expenditures – Costs expensed in
the period they occur.
Example: Routine maintenance expenses.

© 2009 Pearson Prentice Hall. All rights reserved.

Costs Classified as to Variability

Variable Costs – Costs that vary directly

with production volume.
Example: Raw materials such as flour for a
bakery – more bread means more flour is
needed.
Fixed Costs – Costs that remain constant
regardless of production volume.
Example: Factory rent – payable whether
production is high or low.

© 2009 Pearson Prentice Hall. All rights reserved.

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

© 2009 Pearson Prentice Hall. All rights reserved.

Cost Behavior Visualized

© 2009 Pearson Prentice Hall. All rights reserved.

Committed Fixed Costs

Definition: Long-term fixed costs that cannot

be easily changed or eliminated in the short
run.
Nature: Usually tied to long-term
investments and are difficult to reduce
without major operational changes.
Examples:
Depreciation on factory buildings.
Lease payments on production facilities.
Salaries of top executives.
© 2009 Pearson Prentice Hall. All rights reserved.
Managed (Discretionary) Fixed
Costs
Definition: Fixed costs that can be altered or
reduced in the short term at management's
discretion.
Nature: Often related to activities that are
planned annually and can be adjusted
depending on financial goals.
Examples:
Advertising and marketing expenses.
Research and development budgets.
Employee training programs.
© 2009 Pearson Prentice Hall. All rights reserved.
Costs Classified as to Variability

Mixed Costs (Semi-Variable Costs) –

Costs that contain both fixed and variable
components.
Fixed portion: remains constant even if no
production occurs (e.g., base charge for
electricity).
Variable portion: changes depending on
production volume (e.g., cost of electricity used
by machines).
Example: Utility bills with a flat monthly
charge plus additional costs based on usage.
© 2009 Pearson Prentice Hall. All rights reserved.
Step Costs – Costs that remain fixed over
a small range of production but increase
in steps once a threshold is reached.
Example: Hiring an additional supervisor
when production exceeds 500 units.
STEP costs usually have larger cost
jumps compared to semi-variable (mixed)
costs because they increase in discrete
chunks rather than gradually.

© 2009 Pearson Prentice Hall. All rights reserved.

Direct COST
Direct costs – can be conveniently and
economically traced (tracked) to a cost
object.
Costs that can be directly traced to a specific
product, project, or service.
Examples: raw materials, direct labor,
production supplies.

© 2009 Pearson Prentice Hall. All rights reserved.

Direct Costs
Variable Direct Costs: Change with the
level of production or sales.
Example: Raw materials used per unit of
production.
Fixed Direct Costs: Remain constant
regardless of production volume, but are
still directly attributable to the product or
project.
Example: Salaries of dedicated project staff,
equipment rental for a specific job.
© 2009 Pearson Prentice Hall. All rights reserved.
 Comparison

Type of Cost Direct? Variable?

Raw materials Yes Yes

Direct labor (piece
Yes Yes
rate)
Dedicated machine
Yes Fixed
lease

Supervisor’s salary
Yes Fixed
(for one product line)

© 2009 Pearson Prentice Hall. All rights reserved.

CONCLUSION:
Most direct costs are variable, but some
direct costs can be fixed if they do not
fluctuate with production levels.
Not all direct costs are variable.

© 2009 Pearson Prentice Hall. All rights reserved.

Indirect Costs
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.
are expenses that cannot be directly traced
to a specific product, service, or project but
are necessary for overall business operations.

© 2009 Pearson Prentice Hall. All rights reserved.

Characteristics of Indirect Costs

Not directly attributable to a single cost

object (product, service, department).
Often benefit multiple products or
departments simultaneously.
Can be either fixed or variable in nature.

© 2009 Pearson Prentice Hall. All rights reserved.

Examples of Indirect Costs

Rent and utilities for the entire factory or

office.
Salaries of administrative staff (e.g., HR,
accounting).
Depreciation of equipment used across
different projects.
Office supplies not specific to one product.
General insurance and security expenses.

© 2009 Pearson Prentice Hall. All rights reserved.

Types of Indirect Costs

Fixed Indirect Costs – Do not vary with

production volume.
Example: Factory rent, administrative salaries.
Variable Indirect Costs – Fluctuate with
production or business activity.
Example: Indirect materials like lubricants or
cleaning supplies used more as production
increases.

© 2009 Pearson Prentice Hall. All rights reserved.

 Direct vs. Indirect Costs (Quick Comparison)

COMPARISON

Basis Direct Costs Indirect Costs

Cannot be traced to a
Easily traced to a
Traceability single
product/project
product/project
Rent, utilities,
Raw materials, direct
Examples administrative
labor
salaries
Can be variable or Can be variable or
Cost Behavior
fixed fixed

© 2009 Pearson Prentice Hall. All rights reserved.

Costs for Planning, Control, and
Analytical Processes
Standard Costs – Predetermined costs for
production under normal conditions.
Example: Standard cost of producing one unit of a
product.
Opportunity Costs – Potential benefit lost by
choosing one alternative over another.
Example: Choosing to rent a property instead of
using it for own business.
Differential Cost – Difference in cost between
two alternatives.
Example: Cost difference between in-house
production and outsourcing.
© 2009 Pearson Prentice Hall. All rights reserved.
Relevant Cost – Costs that are affected by a
specific decision.
Example: Additional raw materials for an extra
order.
Out-of-Pocket Cost – Actual cash outlay for a
decision.
Example: Payment for materials purchased.
Sunk Cost – Past costs that cannot be recovered.
Example: Equipment purchased last year.
Controllable Cost – Costs that a manager can
influence.
Example: Departmental supply expenses.

© 2009 Pearson Prentice Hall. All rights reserved.

BMW: Assigning Costs to a Cost
Object

© 2009 Pearson Prentice Hall. All rights reserved.

Factors Affecting Direct / Indirect
Cost Classification
Cost Materiality
Availability of information-gathering
technology
Operational Design

© 2009 Pearson Prentice Hall. All rights reserved.

Different Types of Firms
Manufacturing-sector companies – create and
sell their own products
Merchandising-sector companies – product
resellers
Service-sector companies – provide services
(intangible products)

© 2009 Pearson Prentice Hall. All rights reserved.

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

© 2009 Pearson Prentice Hall. All rights reserved.

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 as incurred.

© 2009 Pearson Prentice Hall. All rights reserved.

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

© 2009 Pearson Prentice Hall. All rights reserved.

Cost Flows Visualized

© 2009 Pearson Prentice Hall. All rights reserved.

Cost of Goods Manufactured

© 2009 Pearson Prentice Hall. All rights reserved.

Multiple-Step Income Statement

© 2009 Pearson Prentice Hall. All rights reserved.

Other Cost Considerations
Prime cost is a term referring to all direct
manufacturing costs (labor and materials)
Conversion cost is a term referring to direct
labor and factory overhead costs, collectively
Overtime labor costs are considered part of
overhead due to the inability to precisely
know the true cause of these costs

© 2009 Pearson Prentice Hall. All rights reserved.

Different Definitions of Costs
for Different Applications
Pricing and product-mix decisions – may use
a “super” cost approach (comprehensive)
Contracting with government agencies – very
specific definitions of cost for “cost plus
profit” contracts
Preparing external-use financial statements –
GAAP-driven product costs only

© 2009 Pearson Prentice Hall. All rights reserved.

Different Definitions of Costs
for Different Applications

© 2009 Pearson Prentice Hall. All rights reserved.

Three Common Features of
Cost Accounting & Cost Management
1. Calculating the cost of products, services,
and other cost objects
2. Obtaining information for planning &
control, and performance evaluation
3. Analyzing the relevant information for
making decisions

© 2009 Pearson Prentice Hall. All rights reserved.