Costs Terms, Concepts and Classifications: Chapter Two

Costs Terms, Concepts and
Classifications
Chapter Two
McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

2-2
Learning Objective 1
Identify and give examples

of each of the three basic
manufacturing cost
categories.

2-3
Manufacturing Costs
Direct Direct Manufacturing

Materials Labor Overhead
The Product

2-4
Direct Materials
Raw materials that become an integral part of the

product and that can be conveniently traced
directly to it.
Example: A radio installed in an automobile

2-5
Direct Labor
Those labor costs that can be easily traced to

individual units of product.
Example: Wages paid to automobile assembly workers

2-6
Manufacturing Overhead
Manufacturing costs that cannot be traced directly

to specific units produced.
Examples: Indirect labor and indirect materials
Wages paid to employees Materials used to support

who are not directly the production process.
involved in production
work. Examples: lubricants and
Examples: maintenance cleaning supplies used in the
workers, janitors and automobile assembly plant.
security guards.

2-7
Non-manufacturing Costs
Selling Administrative
Costs Costs
Costs necessary to get All executive,

the order and deliver organizational, and
the product. clerical costs.

2-8
Distinguish between
product costs and period
costs and give examples
of each.

2-9
Product Costs Versus Period Costs
Product costs include Period costs include all

direct materials, direct selling costs and
labor, and administrative costs.
manufacturing
overhead.
Inventory Cost of Good Sold Expense
Sale
Balance Income Income

Sheet Statement Statement
2-10
Quick Check 
Which of the following costs would be considered a

period rather than a product cost in a manufacturing
company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.

2-11
Quick Check 
Which of the following costs would be considered a

period rather than a product cost in a manufacturing
company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.

2-12
Classifications of Costs
Manufacturing costs are often

classified as follows:
Direct Direct Manufacturing
Material Labor Overhead
Prime Conversion
Cost Cost

2-13
Comparing Merchandising and
Manufacturing Activities
Merchandisers . . . Manufacturers . . .
 Buy finished goods.  Buy raw materials.
 Sell finished goods.  Produce and sell
finished goods.
MegaLoMart

2-14
Balance Sheet
Merchandiser Manufacturer
Current assets Current Assets
 Cash  Cash
 Receivables  Receivables
 Prepaid Expenses
 Inventories
 Merchandise
Inventory • Raw Materials
• Work in Process
• Finished Goods

2-15
Balance Sheet
Merchandiser Manufacturer
Current assets Current Assets
 Cash  Cash
 Receivables  Receivables
Materials waiting to
 Prepaid
be processed.
Expenses
Partially complete  Inventories
 Merchandise
products – some
Inventory • Raw Materials
material, labor, or • Work in Process
overhead has been • Finished Goods
added.
Completed products
awaiting sale.
2-16
Prepare an income
statement including
calculation of the cost of
goods sold.

2-17
The Income Statement
Cost of goods sold for manufacturers differs only

slightly from cost of goods sold for merchandisers.
Merchandising Company Manufacturing Company
Cost of goods sold:

Cost of goods sold:
Beg. merchandise Beg. finished
inventory $ 14,200 goods inv. $ 14,200
+ Purchases 234,150 + Cost of goods
Goods available manufactured 234,150
for sale $ 248,350 Goods available
- Ending for sale $248,350
merchandise - Ending
inventory (12,100) finished goods
= Cost of goods inventory (12,100)
sold $ 236,250 = Cost of goods
sold $236,250

2-18
Basic Equation for Inventory Accounts
Withdrawals
Beginning Additions Ending
balance + to inventory = balance + from
inventory

2-19
Quick Check 
If your inventory balance at the beginning of the

month was $1,000, you bought $100 during the
month, and sold $300 during the month, what would
be the balance at the end of the month?
A. $1,000.
B. $ 800.
C. $1,200.
D. $ 200.

2-20
Quick Check 
If your inventory balance at the beginning of the

month was $1,000, you bought $100 during the
month, and sold $300 during the month, what would
be the balance at the end of the month?
A. $1,000.
$1,000 + $100 = $1,100
B. $ 800. $1,100 - $300 = $800
C. $1,200.
D. $ 200.

2-21
Prepare a schedule of cost

of goods manufactured.

2-22
Schedule of Cost of Goods Manufactured
Calculates the cost of raw

material, direct labor and
manufacturing overhead
used in production.
Calculates the manufacturing

costs associated with goods
that were finished during the
period.

2-23
Product Cost Flows
Manufacturing Work
Raw Materials Costs In Process
Beginning raw Direct materials

materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production
– Ending raw materials
inventory
= Raw materials used
As items are removed from raw
in production materials inventory and placed into
the production process, they are
called direct materials.

2-24
Product Cost Flows
Manufacturing Work
Conversion
Beginning raw Direct materials
materials inventory + Direct labor
costs are costs
+ Raw materials + Mfg. overhead incurred to
purchased = Total manufacturing convert the
= Raw materials costs
direct material
available for use
in production into a finished
– Ending raw materials product.
inventory
in production

2-25
Product Cost Flows
Manufacturing Work
Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials
inventory All manufacturing costs incurred
= Raw materials used during the period are added to the
in production
beginning balance of work in
process.

2-26
Product Cost Flows
Manufacturing Work
Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials – Ending work in
inventory
Costs associated with the goods that process inventory
= Raw materials used = Cost of goods
areincompleted
production
during the period are manufactured
transferred to finished goods
inventory.

2-27
Product Cost Flows
Work
In Process Finished Goods
Beginning work in Beginning finished

process inventory goods inventory
+ Manufacturing costs + Cost of goods
for the period manufactured
= Total work in process = Cost of goods
for the period available for sale
– Ending work in - Ending finished
process inventory goods inventory
= Cost of goods Cost of goods
manufactured sold

2-28
Manufacturing Cost Flows
Balance Sheet Income

Costs Inventories Statement
Expenses
Material Purchases Raw Materials
Direct Labor Work in

Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold
Selling and Period Costs Selling and

Administrative Administrative
2-29
Quick Check 
Beginning raw materials inventory was $32,000.

During the month, $276,000 of raw material was
purchased. A count at the end of the month
revealed that $28,000 of raw material was still
present. What is the cost of direct material used?
A. $276,000
B. $272,000
C. $280,000
D. $ 2,000

2-30
Quick Check 
Beginning raw materials inventory was $32,000.

During the month, $276,000 of raw material was
purchased. A count at the end of the month
revealed that $28,000 of raw material was still
present. What is the costBeg.
of direct material used?
raw materials $ 32,000
A. $276,000 + Raw materials
purchased 276,000
B. $272,000 = Raw materials available
for use in production $ 308,000
C. $280,000 – Ending raw materials
D. $ 2,000 inventory 28,000
in production $ 280,000

2-31
Quick Check 
Direct materials used in production totaled

$280,000. Direct labor was $375,000 and
factory overhead was $180,000. What were
total manufacturing costs incurred for the
month?
A. $555,000
B. $835,000
C. $655,000
D. Cannot be determined.

2-32
Quick Check 
Direct materials used in production totaled

$280,000. Direct labor was $375,000 and
factory overhead was $180,000.
Direct Materials What were
$ 280,000
total manufacturing+ costs incurred for the
Direct Labor 375,000
+ Mfg. Overhead 180,000
month? = Mfg. Costs Incurred
A. $555,000 for the Month $ 835,000
B. $835,000
C. $655,000

2-33
Quick Check 
Beginning work in process was $125,000.

Manufacturing costs incurred for the month
were $835,000. There were $200,000 of
partially finished goods remaining in work
in process inventory at the end of the
month. What was the cost of goods
manufactured during the month?
A. $1,160,000
B. $ 910,000
C. $ 760,000
2-34
Quick Check 
Beginning work in process was $125,000.

Manufacturing costs incurred for the month
were $835,000. There were $200,000 of
partially finished goods remaining in work
Beginning work in
in process inventory at the end of the $ 125,000
process inventory
month. What was the +cost of goods
Mfg. costs incurred
for the period 835,000
manufactured during the month?
= Total work in process
A. $1,160,000 – Ending
during the period
work in
$ 960,000
B. $ 910,000 = Costprocess inventory

of goods
200,000
C. $ 760,000 manufactured $ 760,000
2-35
Quick Check 
Beginning finished goods inventory was

$130,000. The cost of goods manufactured
for the month was $760,000. And the ending
finished goods inventory was $150,000.
What was the cost of goods sold for the
month?
A. $ 20,000.
B. $740,000.
C. $780,000.
D. $760,000.
2-36
Quick Check 
Beginning finished goods inventory was

$130,000. The cost of goods manufactured
for the month was $760,000. And the ending
finished goods inventory was $150,000.
What was the cost of goods sold for the
month?
A. $ 20,000. $130,000 + $760,000 = $890,000
B. $740,000. $890,000 - $150,000 = $740,000
C. $780,000.
D. $760,000.
2-37
Understand the
differences between
variable costs and fixed
costs.

2-38
Cost Classifications for Predicting Cost
Behavior
How a cost will react to

changes in the level of
activity within the
relevant range.
 Total variable costs
change when activity
changes.
 Total fixed costs remain
unchanged when activity
changes.

2-39
Variable Cost
Your total long distance telephone bill is based

on how many minutes you talk.
Total Long Distance
Telephone Bill
Minutes Talked
2-40
Variable Cost Per Unit
The cost per long distance minute talked is

constant. For example, 10 cents per minute.
Telephone Charge
Per Minute
Minutes Talked
2-41
Fixed Cost
Your monthly basic telephone bill probably

does not change when you make more local
calls.
Telephone Bill
Monthly Basic
Number of Local Calls

2-42
Fixed Cost Per Unit
The average fixed cost per local call decreases

as more local calls are made.
Monthly Basic Telephone

Bill per Local Call
Number of Local Calls
2-43
Cost Classifications for Predicting Cost
Behavior
Behavior of Cost (within the relevant range)

Cost In Total Per Unit
Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Average fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.

2-44
Quick Check 
Which of the following costs would be variable with

respect to the number of cones sold at a Baskins &
Robbins shop? (There may be more than one
correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.

2-45
Quick Check 
Which of the following costs would be variable with

respect to the number of cones sold at a Baskins &
Robbins shop? (There may be more than one
correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.

2-46
Understand the
differences between direct
and indirect costs.

2-47
Assigning Costs to Cost Objects
Direct costs Indirect costs

• Costs that can be • Costs that cannot be
easily and conveniently easily and conveniently
traced to a unit of traced to a unit of
product or other cost product or other cost
object. object.
• Examples: direct • Example: manufacturing
material and direct labor overhead

2-48
Define and give examples

of cost classifications used
in making decisions:
differential costs,
opportunity costs, and
sunk costs.

2-49
Cost Classifications for Decision Making
• Every decision involves a choice between at

least two alternatives.
• Only those costs and benefits that differ

between alternatives are relevant in a decision.
All other costs and benefits can and should be
ignored.

2-50
Differential Cost and Revenue
Costs and revenues that differ among

alternatives.
Example: You have a job paying $1,500 per month in

your hometown. You have a job offer in a neighboring
city that pays $2,000 per month. The commuting cost
to the city is $300 per month.
Differential revenue is:

$2,000 – $1,500 = $500
Differential cost is:

$300
2-51
Opportunity Cost
The potential benefit

that is given up when
one alternative is
selected over another.
Example: If you were
not attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college for
one year is $15,000.
2-52
Sunk Costs
Sunk costs have already been incurred and

cannot be changed now or in the future.
They should be ignored when making
decisions.
Example: You bought an automobile that cost
$10,000 two years ago. The $10,000 cost is sunk
because whether you drive it, park it, trade it, or sell
it, you cannot change the $10,000 cost.

2-53
Quick Check 
Suppose you are trying to decide whether to drive

or take the train to Portland to attend a concert. You
have ample cash to do either, but you don’t want to
waste money needlessly. Is the cost of the train
ticket relevant in this decision? In other words,
should the cost of the train ticket affect the decision
of whether you drive or take the train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.

2-54
Quick Check 

waste money needlessly. Is the cost of the train
ticket relevant in this decision? In other words,
should the cost of the train ticket affect the decision
of whether you drive or take the train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.

2-55
Quick Check 

waste money needlessly. Is the annual cost of
licensing your car relevant in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.

2-56
Quick Check 

waste money needlessly. Is the annual cost of
licensing your car relevant in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.

2-57
Quick Check 
Suppose that your car could be sold now for

$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.

2-58
Quick Check 
Suppose that your car could be sold now for

$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.

2-59
Summary of the Types of Cost
Classifications
• Financial reporting
• Predicting cost behavior
• Assigning costs to cost objects
• Decision making

Further Classification of Labor
Costs
Appendix 2A

2-61
(Appendix 2A)
Properly account for labor
costs associated with idle
time, overtime, and fringe
benefits.

2-62
Idle Time
Machine Material
Breakdowns Shortages
Power
Failures
The labor costs incurred

during idle time are ordinarily
treated as manufacturing
overhead.
2-63
Overtime
The overtime premiums for all factory

workers are usually considered to be part
of manufacturing overhead.

2-64
Labor Fringe Benefits
Fringe benefits include employer paid

costs for insurance programs, retirement
plans, supplemental unemployment
programs, Social Security, Medicare,
workers’ compensation and
unemployment taxes.
Some companies Other companies treat

include all of these fringe benefit
costs in expenses of direct
manufacturing laborers as additional
overhead. direct labor costs.
Cost of Quality
Appendix 2B

2-66
(Appendix 2B)
Identify the four types of
quality costs and explain
how they interact.

2-67
Quality of Conformance
When the overwhelming majority of

products produced conform to design
specifications and are free from
defects.

2-68
Prevention and Appraisal Costs
Support activities
Prevention whose purpose is to
Costs reduce the number of
defects
Incurred to identify
defective products
Appraisal Costs before the products are
shipped

2-69
Internal and External Failure Costs
Incurred as a result of
Internal Failure
identifying defects
Costs before they are shipped
Incurred as a result of
External Failure defective products
Costs being delivered to
customers

2-70
Examples of Quality Costs
Appraisal Costs
Prevention Costs
• Testing & inspecting
• Quality training
incoming materials
• Quality circles
• Final product testing
• Statistical process
• Depreciation of testing
control activities
equipment
External Failure Costs

Internal Failure Costs
• Cost of field servicing &
• Scrap
handling complaints
• Spoilage
• Warranty repairs
• Rework
• Lost sales

2-71
Distribution of Quality Costs
When quality of conformance is low, total

quality cost is high and consists mostly of
internal and external failure.
Total quality costs drop rapidly as the quality

of conformance increases.
Companies reduce their total quality costs by

focusing their efforts on prevention and
appraisal because the cost savings from
reduced defects usually overwhelm the
costs of additional prevention and
appraisal.
Total quality costs are minimized when the

quality of conformance is slightly less
than 100%.
2-72
(Appendix 2B)
Prepare and interpret a
quality cost report.

2-73 Quality Cost Report
For Years 1 and 2
Year 2 Year 1
Amount Percent* Amount Percent*
Prevention costs:
Systems development $ 400,000 0.80% $ 270,000 0.54%
Quality training 210,000 0.42% 130,000 0.26%
Supervision of prevention activities 70,000 0.14% 40,000 0.08%
Quality improvement 320,000 0.64% 210,000 0.42%
Total prevention cost 1,000,000 2.00% 650,000 1.30%
Appraisal costs: Quality cost

Inspection 600,000 1.20% 560,000 1.12%
Reliability testing 580,000 1.16% 420,000 0.84% reports provide
Supervision of testing and inspection 120,000 0.24% 80,000 0.16%
Depreciation of test equipment 200,000 0.40% 140,000 0.28% an estimate of
Total appraisal cost 1,500,000 3.00% 1,200,000 2.40%
the financial
Internal failure costs:
Net cost of scrap 900,000 1.80% 750,000 1.50%
consequences
Rework labor and overhead 1,430,000 2.86% 810,000 1.62% of the
Downtime due to defects in quality 170,000 0.34% 100,000 0.20%
Disposal of defective products 500,000 1.00% 340,000 0.68% company’s
Total internal failure cost 3,000,000 6.00% 2,000,000 4.00%
current defect
External failure costs:
Warranty repairs 400,000 0.80% 900,000 1.80% rate.
Warranty replacements 870,000 1.74% 2,300,000 4.60%
Allowances 130,000 0.26% 630,000 1.26%
Cost of field servicing 600,000 1.20% 1,320,000 2.64%
Total external failure cost 2,000,000 4.00% 5,150,000 10.30%
Total quality cost $ 7,500,000 15.00% $ 9,000,000 18.00%
* AsMcGraw-Hill/Irwin
a percentage of total sales. In each year sales totaled $50,000,000. Copyright © 2008, The McGraw-Hill Companies, Inc.
2-74
Quality Cost Reports in Graphic Form
$10 20
9
Quality 18
Quality Cost as a Percentage of Sales

8
reports 16
Quality Cost (in millions)
7
External External
can also 14
External External
6 Failure Failure be 12 Failure Failure
5 prepared 10
4 Internal
Failure
in 8 Internal
Failure
3 Internal
Failure
graphic 6 Internal
Failure
2
Appraisal form. 4
Appraisal
Appraisal Appraisal
1 2
Prevention Prevention Prevention Prevention
0 0
1 2 1 2
Year Year
2-75
Uses of Quality Cost Information
Help managers see the

financial significance of
defects.
Help managers identify

the relative importance
of the quality problems.
Help managers see
whether their quality
costs are poorly
distributed.
2-76
Limitations of Quality Cost Information
Simply measuring quality

cost problems does not
solve quality problems.
Results usually lag

behind quality
improvement programs.
The most important

quality cost, lost sales, is
often omitted from
quality cost reports.
2-77
ISO 9000 Standards
ISO 9000 standards have become

international measures of quality.
To become ISO 9000 certified, a
company must demonstrate:
1. A quality control system is in use, and the
system clearly defines an expected level of
quality.
2. The system is fully operational and is
backed up with detailed documentation of
quality control procedures.
3. The intended level of quality is being
achieved on a sustained basis.

2-78
End of Chapter 2

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Costs Terms, Concepts and

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

Identify and give examples

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Direct Direct Manufacturing

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Raw materials that become an integral part of the

Example: A radio installed in an automobile

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Those labor costs that can be easily traced to

Example: Wages paid to automobile assembly workers

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

Manufacturing costs that cannot be traced directly

Examples: Indirect labor and indirect materials

Wages paid to employees Materials used to support

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

Costs necessary to get All executive,

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

Product Costs Versus Period Costs

Product costs include Period costs include all

Inventory Cost of Good Sold Expense

Balance Income Income

Which of the following costs would be considered a

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Which of the following costs would be considered a

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Manufacturing costs are often

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The Income Statement

Cost of goods sold for manufacturers differs only

Merchandising Company Manufacturing Company

Cost of goods sold:

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Basic Equation for Inventory Accounts

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If your inventory balance at the beginning of the

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If your inventory balance at the beginning of the

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Prepare a schedule of cost

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Schedule of Cost of Goods Manufactured

Calculates the cost of raw

Calculates the manufacturing

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Product Cost Flows

Beginning raw Direct materials

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Product Cost Flows

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Product Cost Flows

Beginning raw Direct materials Beginning work in

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Product Cost Flows

Beginning raw Direct materials Beginning work in