An Introduction to Cost Terms and Purposes

Overview

This chapter introduces the basic terminology of cost accounting. Communication among managers and management accountants is greatly facilitated by having a common understanding of the meaning of cost terms and concepts. The chapter illustrates a major theme of the textbook: using different costs for different purposes. The chapter also provides a framework to help you understand cost accounting and cost management.

Review Points

1. Accountants define cost as a resource sacrificed (used) or forgone to achieve a specific objective. For example, it might cost $3,000 per month to rent a building. To guide their decisions, managers often want to know how much a particular thing costs. This “thing” is called a cost object, anything for which a measurement of costs is desired. In the following questions, the cost object is in italics: What selling price should be charged for a product? Which machine is the least expensive to operate?

2. Costing systems account for costs in two basic stages. The first stage is cost accumulation, the collection of cost data in some organized way by means of an accounting system. The second stage is cost assignment, a general term that encompasses both (a) tracing accumulated costs that have a direct relationship to a cost object and (b) allocating accumulated costs that have an indirect relationship to a cost object.

3. A key question in cost assignment is whether costs have a direct or an indirect relationship to the particular cost object.

• The direct costs of a cost object are related to the particular cost object and can be traced to that cost object in an economically feasible (cost-effective) way. The term cost tracing describes the assignment of direct costs to the particular cost object.
• The indirect costs of a cost object are related to the particular cost object but cannot be traced to that cost object in an economically feasible way. The term cost allocation describes the assignment of indirect costs to the particular cost object.

Several factors affect the classification of a cost as direct or indirect: the materiality (relative importance) of the cost in question, available information-gathering technology, design of operations, and contractual arrangements.


4. Consider this question: Is a production department manager’s salary a direct cost or an indirect cost? The answer: It depends on the choice of the cost object. For example, if the cost object is the production department, the salary is a direct cost because it can be traced to the cost object. But if the cost object is one of the many products manufactured in the production department, the salary is an indirect cost because it can be allocated (but not traced) to the cost object.

5. Two basic types of cost-behavior patterns are found in accounting systems.

• A variable cost changes in total in proportion to changes in the related level of total activity or volume. A variable cost does not change on a per unit basis when the related level of total activity or volume changes.
• A fixed cost remains unchanged in total for a given time period despite wide changes in the related level of total activity or volume. A fixed cost increases (decreases) on a per unit basis when the related level of total activity or volume decreases (increases).

Costs are variable or fixed with respect to a specific cost object and for a given time period. A relevant range is the span of normal activity or volume level in which there is a specific relationship between the activity or volume level and the cost in question.

6. A cost driver is a variable, such as the level of activity or volume, that causes costs to increase or decrease over a given time period. In other words, a cause-and-effect relationship exists between a change in the level of activity or volume and a change in the level of total costs.

• The cost driver of variable costs is the level of activity or volume whose change causes these costs to change proportionately. For example, the number of trucks assembled is a cost driver of the cost of steering wheels for the trucks.
• Fixed costs have no cost driver in the short run but may have a cost driver in the long run. For example, the equipment and staff costs of product testing typically are fixed in the short run with respect to changes in the volume of production. In the long run, however, the company increases or decreases these costs to the levels needed to support future production levels.

7. Accounting systems typically report both total costs and unit costs (also called average costs). A unit cost is computed by dividing some amount of total costs by the related number of units. Unit costs are regularly used in financial reports. For many decisions, however, managers should think in terms of total costs rather than unit costs because fixed cost per unit changes when the related level of total volume changes. Unit costs, therefore, should be interpreted with caution if they include a fixed-cost component. The Tennessee Products example, text p. 38, illustrates this important point.

8. Companies in the manufacturing, merchandising, and service sectors of the economy are frequently referred to in the study of cost accounting.

• Manufacturing-sector companies purchase materials and components and convert them into various finished goods. These companies typically have three types of inventory: direct materials inventory, work-in-process inventory, and finished goods inventory.
• Merchandise-sector companies purchase and then sell tangible products without changing their basic form. These companies have one type of inventory: merchandise inventory.
• Service-sector companies provide services or intangible products—for example, legal advice, checking accounts, or audits—to their customers. These companies do not have an inventory of items for sale.

9. For companies with inventories, generally accepted accounting principles distinguish inventoriable costs from period costs.

• Inventoriable costs are all costs of a product that are regarded as an asset when they are incurred and then become cost of goods sold when the product is sold. For manufacturing companies, all manufacturing costs are inventoriable costs. For merchandising companies, inventoriable costs are the acquisition costs of merchandise. Because service companies have no inventories, they have no inventoriable costs.
• Period costs are all costs in the income statement other than cost of goods sold. Period costs are treated as expenses of the period in which they are incurred.

10. Three terms are widely used in describing manufacturing costs. In the following definitions, “the cost object” refers to “work in process and then finished goods.”

• Direct material costs are the acquisition costs of all materials that eventually become part of the cost object and that can be traced to that cost object in an economically feasible way.
• Direct manufacturing labor costs include the compensation of all manufacturing labor that can be traced to the cost object in an economically feasible way.
• Indirect manufacturing costs (also called manufacturing overhead costs or factory overhead costs) are all manufacturing costs that are related to the cost object but that cannot be traced to that cost object in an economically feasible way. Examples include power, indirect materials, indirect manufacturing labor, plant insurance, plant depreciation, and compensation of plant managers.

11. In the income statement of a manufacturing company, cost of goods sold is computed as follows (figures assumed):

Beginning finished goods $ 50,000
Add cost of goods manufactured 800,000
Cost of goods available for sale 850,000
Deduct ending finished goods 60,000
Cost of goods sold $790,000

The line item, cost of goods manufactured, refers to the cost of all goods brought to completion, whether they were started before or during the current accounting period. Cost of goods manufactured is often computed in a supporting schedule to the income statement as follows (figures assumed):

Beginning direct materials $ 60,000
Add purchases of direct materials 510,000
Direct materials available for use 570,000
Deduct ending direct materials 50,000
Direct materials used 520,000
Add direct manufacturing labor 100,000
Add indirect manufacturing costs 230,000
Manufacturing costs incurred during the period 850,000
Add beginning work in process 120,000
Total manufacturing cost to account for 970,000
Deduct ending work in process 170,000
Cost of goods manufactured $800,000

EXHIBIT 2-7, text p. 41, shows the flow of manufacturing costs in the general ledger, from Work-in-Process Inventory to Finished Goods Inventory to Cost of Goods Sold.

12. Manufacturing costing systems use the terms prime costs and conversion costs.

• Prime costs are all direct manufacturing costs. Under the three-part classification of manufacturing costs in paragraph 10, prime costs are equal to direct material costs plus direct manufacturing labor costs. In cases where other direct manufacturing cost categories are used, they too are prime costs. For example, power costs could be classified as a direct cost if the power is metered to specific areas of a plant that are dedicated to manufacturing separate products.
• Conversion costs are all manufacturing costs other than direct material costs; they are incurred to transform direct materials into finished goods. Under the three-part classification of manufacturing costs, conversion costs are equal to direct manufacturing labor costs plus indirect manufacturing costs.

13. All manufacturing labor compensation, except for direct labor and managers’ salaries, is usually classified as indirect labor costs—a major component of manufacturing overhead. Two main categories of indirect labor in manufacturing and service companies are overtime premium and idle time. Overtime premium consists of the wage rate paid to workers (for both direct labor and indirect labor) in excess of their straight-time wage rates. Overtime premium is classified as overhead when the overtime is attributable to the heavy overall volume of work. When a particular job, such as a rush order, is the sole reason for the overtime, the overtime premium is classified as a direct cost of that job. Idle time is wages paid for unproductive time caused by lack of orders, machine breakdowns, material shortages, poor scheduling, and the like.

14. Some manufacturing companies classify payroll fringe benefit costs of direct labor as overhead cost, whereas others classify them as direct labor cost. The latter approach is preferable because these payroll fringe benefit costs are a fundamental aspect of acquiring the direct manufacturing labor services. To prevent disputes about cost items such as payroll fringe benefits, training time, overtime premium, idle time, vacations, and sick leave, contracts and laws should be as specific as feasible regarding definitions and measurements. The example, text p. 45, shows that the classification of payroll fringe benefits can be important for income tax purposes.

15. An important theme of the textbook is using different costs for different purposes. For example, managers can assign different costs to a product depending on their purpose. A product cost is the sum of costs assigned to a product for a specific purpose, such as (a) preparing financial statements for external reporting under generally accepted accounting principles (GAAP), (b) contracts with government agencies, or (c) pricing and product-mix decisions. For financial statements based on GAAP, a product cost includes only inventoriable costs. A product cost includes a broader set of costs for reimbursement under government contracts, or a still broader set of costs for pricing and product-mix decisions.

16. Three important aspects of cost accounting and cost management are:

a. Calculating the cost of products, services, and other cost objects.
b. Obtaining information for planning and control and performance evaluation.
c. Analyzing the relevant information for decision making.