Chapter One: INTRODUCTION TO COST TERMS AND

PURPOSES.
Summary objectives.
1. What is a cost object?
A cost object is anything for which a separate measurement of cost is needed. Examples include a
product, a service, a project, a customer, a brand category, an activity, and a department.

2. How do managers decide whether a cost is a direct or an indirect cost?

A direct cost is any cost that is related to a particular cost object and can be traced to that cost
object in an economically feasible way. Indirect costs are related to the particular cost object but
cannot be traced to it in an economically feasible way. The same cost can be direct for one cost
object and indirect for another cost object. This book uses cost tracing to describe the assignment
of direct costs to a cost object and cost allocation to describe the assignment of indirect costs to a
cost object.
3. How do managers decide whether a cost is a variable or a fixed cost?
A variable cost changes in total in proportion to changes in the related level of total activity or
volume. A fixed cost remains unchanged in total for a given time period despite wide changes in
the related level of total activity or volume.
4. How should costs be estimated?
In general, focus on total costs, not unit costs. When making total cost estimates, think of variable
costs as an amount per unit and fixed costs as a total amount. The unit cost of a cost object should
be interpreted cautiously when it includes a fixed-cost component.
5. What are the differences in the accounting for inventor able versus period costs?
Inventor able costs are all costs of a product that are regarded as an asset in the accounting period
when they are incurred and become cost of goods sold in the accounting period when the product
is sold. Period costs are expensed in the accounting period in which they are incurred and are all
of the costs in an income statement other than cost of goods sold.
6. Why do managers assign different costs to the same cost objects?
Managers can assign different costs to the same cost object depending on the purpose. For
example, for the external reporting purpose in a manufacturing company, the inventor able cost of
a product includes only manufacturing costs. In contrast, costs from all business functions of the
value chain often are assigned to a product for pricing and product-mix decisions.
7. What are the three key features of cost accounting and cost management?
Three features of cost accounting and cost management are (1) calculating the cost of products,
services, and other cost objects; (2) obtaining information for planning and control and
performance evaluation; and (3) analyzing relevant information for making decisions.
Costs and Cost Terminology
Accountants define cost as a resource sacrificed or forgone to achieve a specific objective. A cost
(such as direct materials or advertising) is usually measured as the monetary amount that must be
paid to acquire goods or services. An actual cost is the cost incurred (a historical or past cost), as
distinguished from a budgeted cost, which is a predicted or forecasted cost (a future cost).
Direct Costs and Indirect Costs
Direct costs of a cost object are related to the particular cost object and can be traced to it in an
economically feasible (cost-effective) way Indirect costs of a cost object are related to the
particular cost object but cannot be traced to it in an economically feasible (cost-effective) way.
Factors Affecting Direct/Indirect Cost Classifications.

The materiality of the cost in question. The smaller the amount of a cost—that is, the more
immaterial the cost is—the less likely that it is economically feasible to trace that cost to a
particular cost object.
Available information-gathering technology. Improvements in information-gathering technology
make it possible to consider more and more costs as direct costs
Design of operations.
Classifying a cost as direct is easier if a company’s facility (or some part of it) is used exclusively
for a specific cost object, such as a specific product or a particular customer.
Cost-Behavior Patterns: Variable Costs and Fixed Costs.
A variable cost changes in total in proportion to changes in the related level of total activity or
volume.
A fixed cost remains unchanged in total for a given time period, despite wide changes in the related
level of total activity or volume.
Cost Drivers
A cost driver is a variable, such as the level of activity or volume that causally affects Costs over
a given time span. An activity is an event, task, or unit of work with a specified purpose—for
example, designing products, setting up machines, or testing products.
The level of activity or volume is a cost driver if there is a cause-and-effect relationship between
a change in the level of activity or volume and a change in the level of total Costs.
Unit Costs
Accounting systems typically report both total-cost amounts and average-cost-per unit amounts.
A unit cost, also called an average cost, is calculated by dividing total
Cost by the related number of units. The units might be expressed in various ways.
Examples are automobiles assembled, packages delivered, or hours worked. Suppose that, in 2011,
its first year of operations, $40,000,000 of manufacturing costs are Incurred to produce 500,000
speaker systems at the Memphis plant of Tennessee Products. Then the unit cost is $80:
Manufacturing-, Merchandising-, and Service-Sector Companies
We define three sectors of the economy and provide examples of companies in each sector.
1. Manufacturing-sector companies purchase materials and components and convert them into
various finished goods. Examples are automotive companies such as Jaguar, cellular phone
producers such as Nokia, food-processing companies such as Heinz, and computer companies such
as Toshiba.
2. Merchandising-sector companies purchase and then sell tangible products without changing
their basic form. This sector includes companies engaged in retailing (for example, bookstores
such as Barnes and Noble or department stores such as Target), distribution (for example, a
supplier of hospital products, such as Owens and Minor), or wholesaling (for example, a supplier
of electronic components, such as Arrow Electronics).
3. Service-sector companies provide services (intangible products)—for example, legal advice or
audits—to their customers. Examples are law firms such as Wachtell, Lipton, Rosen & Katz,
accounting firms such as Ernst and Young, banks such as Barclays, mutual fund companies such
as Fidelity, insurance companies such as Aetna, transportation companies such as Singapore
Airlines, advertising agencies such as Saatchi & Saatchi, television stations such as Turner
Broadcasting, Internet service providers such as Comcast, travel agencies such as American
Express, and brokerage firms such as Merrill Lynch.
Types of Inventory
Manufacturing-sector companies purchase materials and components and convert them into
various finished goods. These companies typically have one or more of the following three types
of inventory:
1. Direct materials inventory. Direct materials in stock and awaiting use in the manufacturing
process (for example, computer chips and components needed to manufacture cellular phones).
2. Work-in-process inventory. Goods partially worked on but not yet completed (for example,
cellular phones at various stages of completion in the manufacturing process). This is also called
work in progress.
3. Finished goods inventory. Goods (for example, cellular phones) completed but not yet sold.

Commonly Used Classifications of Manufacturing Costs

Three terms commonly used when describing manufacturing costs are direct material costs, direct
manufacturing labor costs, and indirect manufacturing costs. These terms build on the direct versus
indirect cost distinction we had described earlier, in the context of manufacturing costs.
1. Direct material costs are the acquisition costs of all materials that eventually become part of
the cost object (work in process and then finished goods) and can be traced to the cost object in an
economically feasible way. Acquisition costs of direct materials include freight-in (inward
delivery) charges, sales taxes, and custom duties. Examples of direct material costs are the steel
and tires used to make the BMW X5, and the computer chips used to make cellular phones.
2. Direct manufacturing labor costs include the compensation of all manufacturing labor that
can be traced to the cost object (work in process and then finished goods) in an economically
feasible way. Examples include wages and fringe benefits paid to machine operators and assembly-
line workers who convert direct materials purchased to finished goods.
3. Indirect manufacturing costs are all manufacturing costs that are related to the cost object
(work in process and then finished goods) but cannot be traced to that cost object in an
economically feasible way. Examples include supplies, indirect materials such as lubricants,
indirect manufacturing labor such as plant maintenance and cleaning labor, plant rent, plant
insurance, property taxes on the plant, plant depreciation, and the compensation of plant managers.
This cost category is also referred to as manufacturing overhead costs or factory overhead costs.
We use indirect manufacturing costs and manufacturing overhead costs interchangeably in this
boo.
Inventor able Costs
Inventor able costs are all costs of a product that are considered as assets in the balance sheet when
they are incurred and that become cost of goods sold only when the product is sold
Period Costs
Period costs are all costs in the income statement other than cost of goods sold. Period costs, such
as marketing, distribution and customer service costs, are treated as expenses of the accounting
period in which they are incurred because they are expected to benefit revenues in that period and
are not expected to benefit revenues in future period

A Framework for Cost Accounting and Cost Management

Three features of cost accounting and cost management across a wide range of applications are as
follows:
1. Calculating the cost of products, services, and other cost objects
2. Obtaining information for planning and control and performance evaluation
3. Analyzing the relevant information for making decisions