Session 2

An Introduction to Cost Terms and Purposes

1
Example to Think About……

You have been hired by Electra to be the accountant for

their bicycle division.
The bicycle division manufactures two types of bicycles:
road bicycle, and mountain bicycle.
You need to discuss some cost issues with the manager at the
next meeting.
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 Example to Think About……

Questions:
1. For pricing purpose, you need to determine the production
costs for each type of bicycle. How to allocate the factory
rent?
2. Anticipating increased sales volume next year, Electra plans
to double the bicycle production volume. How is this going
to affect the manufacturing costs?
3. Some mountain bicycles are manufactured but not sold
immediately. How to prepare the income statement by
matching expenses and revenue?
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Example to Think About……

Direct Cost
Question 1 vs.
Indirect Cost

Fixed Cost
Question 2 vs.
Variable Cost

Inventoriable Cost
Question 3 vs.
Period Cost

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 Part 2.1.
Direct Cost vs. Indirect Cost

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 Cost
 Sacrificed resource to achieve a specific objective
 Normally in monetary term

 Cost measurement can be complicated:

 Currency
 Monetary vs. non-monetary cost, etc.

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 Cost Object -- DELL

Specific Product Dell OptiPlex 24 7000 Series

Project Promotional campaign

Product Category Laptop vs. Desktop

Department Customer service department

Region U.S., Asia, Europe

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 Direct Cost and Indirect Cost

 Direct Costs
 can be conveniently and economically traced
(tracked) to a cost object
 parts of the computer, e.g., hard disk
 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
 depreciation of the assembly line; detergents

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 Direct Cost vs. Indirect Cost

The direct/indirect classification depends on the cost

materiality of the cost in question.

Any discussion about direct vs. indirect costs is cost-

object specific!

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 Cost Object & Direct / Indirect Cost

Qualiten is a car assembly company, assembling two types of

cars: Type A, and Type B.

Cost Object 1 Cost Object 2

Type-A cars Assembly
department
Salary of the manager in
the assembly department
Assembly factory rent

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 Part 2.2.
Fixed Cost vs. Variable Cost

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Definition for Variable /Fixed Costs

A variable cost
changes in total in proportion to changes in the
related level of activity.

A fixed cost
remains unchanged in total for a given time
period, despite wide changes in the related level
of activity.

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 Graphs of Variable and Fixed Costs
Broadband Connection:
1) Hourly package: $4 per hour
2) Monthly Package: $100, no limit on usage time and downloading
volume
Variable

Fixed
4x

cost
cost

Y=

Y=100

Hours (x) Hours (x)

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 Relevant Range
 Relevant range is 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.
 Fixed costs are considered fixed only within the relevant range.
 Cost Driver
 Variable costs are costs that increase incrementally as a driver
increases. A cost driver is an activity or event that causes a cost
to increase.

 All variable costs must have a driver.

 Two of the most common drivers used in managerial

accounting are units and hours, but there are lots of different
drivers that could be used like customers or miles.
 Exercise
Task 2: Match cost drivers with each of activities in the smartphone marker’s value chain.
Reference number Cost driver
1 Number of smartphones sold by the smartphone maker
2 Number of design changes
3 Number of deliveries made to mobile phone companies
4 Engineering hours spent on initial product design
5 Hours spent on research and study of competing brands in the market
6 Customer service hours
7 Number of smartphone orders processed
8 Machine hours required to run the production equipment

Cost driver
Value chain category Value-chain activity
(by ref. no.)
Design of products & processes Perform research (incl. collect data) and study on competing brands
  Design a prototype of the new smartphone
  Make design changes to the smartphone based on customer feedback
Production Manufacture the new smartphones
Marketing (including selling) promote and sell the newly designed phone to mobile phone
companies
Distribution Process orders from mobile phone companies
  Deliver the new smartphones to mobile phone companies
Customer service Provide on-line assistance to mobile phone users for use of the new
smartphone
 Exercise: Classification of Costs
HEC operates a store which includes a video section and a
music section. HEC reports revenues for each section
separately. Classify the following cost items with respect to
the video section:
D/I F/V
Annual retainer paid to a video distributor
Costs of videos purchased for sale to
customers
Subscription to Video Trends magazine
Leasing of computer software for financial
budgeting
Cost of popcorn provided free to customers
Earthquake insurance
Freight-in costs of videos purchased by HEC
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 Part 2.3.
Inventoriable Costs vs. period costs

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Inventoriable Cost vs. Period Cost

 Matching Principle in Accounting

 Match expense with revenue

 Inventoriable Cost vs. Period Cost

 How to match Cost of Goods Sold (COGS)
with revenue

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Service-Sector Companies

Service companies
provide services or intangible
products to their customers.

Labor is the most significant cost category.

Example: McKinsey, Citigroup

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Merchandising Companies

Merchandising companies
purchase and then sell tangible products
without changing their basic form.

Example: Walmart, Waterstone

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Manufacturing Companies

Manufacturing companies
purchase materials and components and
convert them into finished goods.

A manufacturing company must also develop,

design, market, and distribute its products.

Example: Dell, P&G, Mercedes

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 Service Merchandisin Manufacturin
g g
Company
Company Company
Direct
Materials

Work-in-
Process (WIP)

Finished
Goods

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 Merchandising Company

Supplier Inventory Store Consumer

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26
 Cost of Goods Sold (COGS)
Beginning Finished Goods Note:
1) Cost of purchase includes

+ import duties or tariffs and

freight-in costs.
Cost of Goods Purchased 2) Inventory cost assumptions
need to be made, like FIFO,
LIFO, WA
-
Cost of Goods Sold

=
Ending Finished Goods
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 Merchandising Company

Inventory
Beginning Bal. $22,000 Cost of Goods $108,000
Cost of Goods 104,000 Sold
Purchased
Ending Bal. $18,000

Cost of Goods Sold

$108,000

Ending Bal. $108,000

Note: Numbers are made up for illustration purpose. 28

 Inventoriable Costs vs. Period Costs
(Merchandiser)
 Inventoriable Costs
 Capitalized as assets (inventory) until they are sold
and transferred to Cost of Goods Sold
 under GAAP/IFRS: purchase costs, freight in, and
any other costs required to bring them to the location
and condition needed for their eventual sale.

 Period Costs
 Costs that are not tied to inventory, expensed as
incurred
 Under GAAP/IFRS: e.g., R&D, administration,
marketing, distribution, etc. 29
To ask or think about…
 Goods purchased but are still on the way..

 Transportation fee incurred from the port to the internal warehouse?

 Transportation costs incurred between internal warehouses and retail
stores for a merchandiser?
 Storage and handling costs for the purchased goods?

 Goods sold with a right of return;

 Goods sold with a repurchase clause, etc.
Exercise: Merchandiser
Sales revenue $400
Beginning inventory 3 units at $12 each
New purchase 18 units at $13 each
Ending inventory 5 units
Rent $50
Staff salary $20
Utility cost $10
Depreciation cost $15

Required: Prepare the income statement using FIFO.

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Exercise

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 Value Chain for Manufacturers

Research & Product Customer

Production Marketing Distribution
Development Design Service

R&D Marketing Customer

Production Distribution
Department & Sales Service
Department Department
Department Center

General Purchase IT
Other
Administration Department Department

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 Cost Classification for Manufacturers

DM: Direct Materials

Manuf.
Costs DL: Direct Labor

Total MO: Manufacturing Overhead

costs (Indirect Manufacturing Costs)
Admin Expenses
Selling Expenses
Non-Manuf.
Costs
Distribution Expenses
R&D Expenses
Customer-Service Expenses, etc.

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 DM, DL, & MO

 The classification of manuf. costs into DM, DL & MO applies

to the majority of manuf. companies in practice;

 DM: materials that eventually become part of the final product;

 DL: salary of all manuf. labor that can be traced to the cost object;
 MO: all indirect manuf. costs
 indirect material
 indirect labor
 Property tax, rent, utility, insurance, etc.

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 Prime Costs & Conversion Costs

Direct Direct Prime

Materials + Labor = Costs

Direct
Labor + Manuf.
Overhead = Conversion
Costs

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 Inventoriable Costs vs. Period Costs

 Inventoriable Costs
 Capitalized as assets (inventory) until they are sold and
transferred to Cost of Goods Sold
 under GAAP/IFRS: DM, DL, Manuf. Overhead

 Period Costs
 Costs that are not tied to inventory, expensed as incurred
 Under GAAP/IFRS: all non-manufacturing costs,
including R&D, administration, marketing, distribution,
etc.

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Exercise: Period or Inventoriable cost?

1. Company president’s annual bonus

2. Plastic gallon containers in which milk is
packaged
3. Depreciation on marketing department’s
computers
4. Gasoline used to operate refrigerated
trucks used to deliver finished dairy
products to grocery store

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Exercise: Period or Inventoriable cost?

5. Research and Development on improving

milk pasteurization process

6. Cost of milk purchased from dairy farmers

7. Lubricants used in running bottling machines
8. Depreciation on refrigerated trucks used to
collect raw milk from dairy farms
9. Property tax on dairy processing plant

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 Manufacturing Company

Supplier Direct
Material

Direct
Labor COGS

Indirect
Manuf.
Costs Finished Goods
Raw Material
Inventory
Inventory

Work In Process
Consumer
Inventory 40
 Manufacturing Company

BALANCE SHEET INCOME STATEMENT

Inventoriable
Costs Revenues
when deduct
Finished sales
Materials occur Cost of
Goods
Inventory Goods Sold
Inventory
Equals Gross Margin
deduct
Work in
Process Period
Inventory Costs
Equals Operating Income
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 Direct Materials Inventory
Beginning Direct Materials
Direct Materials Used =

+ Beginning Direct Materials

+ New Purchase –
Purchase of Direct Materials Ending Direct Materials

-
Direct Materials Used

=
Ending Direct Materials
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 WIP Inventory
Beginning WIP

+ Cost of Goods
Manufacturing Cost Manufactured = Beginning
i) Direct Materials Used, WIP + Manufacturing Cost
ii) Direct Labor, – Ending WIP
iii) Manufacturing Overhead

- Cost of Goods Manufactured

& Transferred to FG

= Ending WIP 43
 Finished Goods Inventory
Beginning Finished Goods

+
Cost of Goods Manufactured
& Transferred to FG
Income
- Statement
Cost of Goods Sold

=
Ending Finished Goods
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 Accounting Entries
Note: Numbers are made up for illustration purpose.
Direct Materials Finished Goods
Beginning Bal. $11,000 Direct Materials $76,000 Beginning Bal. $22,000 Cost of Goods $108,000
Used
Purchases 73,000 Cost of Goods 104,000 Sold
Manufactured
Ending Bal. $8,000 Ending Bal. $18,000

WIP Cost of Goods Sold

Beginning Bal. $6,000 Cost of Goods $104,000
Manufactured $108,000
Direct Materials 76,000
Used
Direct Labor 9,000 Ending Bal. $108,000
Manufacturing
Overhead 20,000

Ending Bal. $7,000 45

Cost Flows through Financial Statement
 Exercise
Raw materials purchased 16
Rent (factory space) 15
Beginning raw materials 5
Factory utilities 10
Ending raw materials 3
Beginning WIP -
Salaries – production staff 19
Salaries – company secretary 7
Depreciation—production equipment 6
Distribution costs 12
Sales 120
Beginning finished goods 14
Ending WIP 2
Ending finished goods 8
Marketing costs 13
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 Exercise– Direct Materials Used

Beginning raw materials

Plus: Raw materials purchased
Less: Ending raw materials
= Direct Materials Used

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 Exercise– Cost of Goods Manufactured

Beginning WIP

Plus: Manufacturing Cost

Direct Materials

Direct Labor

Manufacturing Overhead

Less: Ending WIP

Cost of Goods Manufactured

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 Exercise– Cost of Goods Sold

Beginning Finished Goods Stock

Plus: Cost of Goods Manufactured

Less: Ending Finished Goods Stock

Cost of Goods Sold

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 Exercise– Profit and Loss Statement

Turnover

Less: Cost of Goods Sold

Gross Margin

Less: Period Costs

Operating Profit

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 Type of Inventoriable Period
Company Product Costs Costs

Service Company None All costs

Purchases plus cost of All costs except total

Merchandiser
freight, import duties, etc. purchases

All costs except DM,

Manufacturer DM, DL, MOH
DL, MOH

Accounting Inventory on balance

Immediately expense
Treatment sheet until sold

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 Cost Assignment to a Product

Type of Cost Cost Assignment

Cost Tracing
Direct Cost
Manufacturing Inventoriable
Cost Cost Allocation Cost
Indirect Cost

Non-Manuf. Costs : Income

Period Costs Statement

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 Additional Notes

 For reporting purpose, no need to differentiate betw.

direct and non-direct non-manufacturing costs since they
are expensed no matter whether they are direct or
indirect;

 Total product cost: for pricing purpose or other decision-

making purpose, management accountants may also
need to classify non-manufacturing costs as direct or
indirect.

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 Direct vs. Indirect Costs
Cost object: product

Direct Manuf. Costs

Manuf.
Costs
Indirect Manuf. Costs

Costs
Direct Non-Manuf. Costs
Non-
manuf.
Costs Indirect Non-Manuf. Costs

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 Exercise
Cost object: a specific product for a manufacturer with multiple products.

Utility costs
(e.g., water,
electricity)
 Exercise
Fire loss, computing inventory costs

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