11th Edition

Chapter 2

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 Costs Terms, Concepts and
Classifications

Chapter Two

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 Manufacturing Costs

Direct Direct Manufacturing

Materials Labor Overhead

The Product

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 Direct Materials

Raw materials that become an integral part of the

product and that can be physically &
conveniently traced to it.

Example: A radio installed in an automobile

Sometimes it isnt worth the effort to trace the costs of

relatively insignificant materials to the end products.
McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.
 Direct Labor

Those labor costs that can be easily traced to

individual units of product.
Direct labor is sometimes referred to as touch labor since it
consists of the costs of workers who touch the product as
it is being made.

Example: Wages paid to automobile assembly workers

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.
 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
involved in production
work.
Examples: maintenance
workers, janitors and
security guards.
the production process.
Examples: lubricants and
cleaning supplies used in the
automobile assembly plant.

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 Classifications of Costs

Manufacturing costs are often

classified as follows:

Direct Direct Manufacturing

Material Labor Overhead

Prime Conversion
Cost Cost

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 Non-manufacturing Costs

Marketing or Administrative
Selling Cost Cost

Costs necessary to get All executive,

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

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 Product Costs Versus Period Costs

Product costs include Period costs include all

direct materials, direct marketing or selling
labor, and manufacturing costs and
overhead.
administrative costs.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.
 Comparing Merchandising and
Manufacturing Activities
Merchandisers . . . Manufacturers . . .
Buy finished goods. Buy raw materials.
Sell finished goods. Produce and sell
finished goods.

MegaLoMart

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 Cost of Goods Manufactured

Direct materials:
Raw materials beginning inventory
Add: Purchases of raw materials
Raw materials available for use
Deduct: Raw materials ending inventory
Raw materials used in production

Direct Labor

Manufacturing overhead
Total manufacturing costs
Add: WIP beginning inventory
Deduct: WIP ending inventory
Cost of goods manufactured

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 Cost of Goods Sold

Finished goods beginning inventory

Add: Cost of goods manufactured
Goods available for sale
Deduct: Finished goods ending inventory
Cost of goods sold

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 Income Statement

Sales
Less cost of goods sold
Gross margin
Less selling and administrative expenses
Net operating income

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 Example

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 Example Contd.

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 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
D. Cannot be determined.
McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.
 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 atBeginning
the endwork in
of the $ 125,000
process inventory
month. What was the+ Mfg.
cost ofincurred
costs goods
for the period 835,000
manufactured during =the
Totalmonth?
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

D. Cannot be determined.
McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.
 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.
McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.
 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.
McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.
 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.

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 Total Variable Cost

Your total long distance telephone bill is based

on how many minutes you talk.
Total Long Distance
Telephone Bill

Minutes Talked
McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.
 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
McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.
 Total 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

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.
 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
McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.
 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.

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 Assigning Costs to Cost Objects

Direct costs Indirect costs

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

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 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.

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

 Differential Costs and Revenues

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
McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.
 Opportunity Costs

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.
McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.
 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: To illustrate a sunk cost, assume that a

company paid $50,000 several years ago for a special-
purpose machine. The machine was used to make a
product that is now obsolete and is no longer being sold.
Even though in hindsight the purchase of the machine may
have been unwise, the $50,000 cost has already been
incurred and cannot be undone.

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.