Costs Terms, Concepts and

Classifications

Chapter Two
 Manufacturing Costs

Direct
Direct Direct
Direct Manufacturing
Manufacturing
Materials
Materials Labor
Labor Overhead
Overhead

The Product
 Direct Materials

Raw materials that become an integral part of the

product and that can be conveniently traced
directly to it.

Example:
Example: A
A radio
radio installed
installed in
in an
an automobile
automobile
 Direct Labor

Those labor costs that can be easily traced to

individual units of product.

Example:
Example: Wages
Wages paid
paid to
to automobile
automobile assembly
assembly workers
workers
 Manufacturing Overhead

Manufacturing costs that cannot be traced directly

to specific units produced.

Examples:
Examples: Indirect
Indirect labor
labor and
and indirect
indirect materials
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.
 Classifications of Costs

Manufacturing costs are often

classified as follows:

Direct
Direct Direct
Direct Manufacturing
Manufacturing
Material
Material Labor
Labor Overhead
Overhead

Prime Conversion
Cost Cost
 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.
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
 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.
 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.
 Comparing Merchandising and
Manufacturing Activities
Merchandisers . . . Manufacturers . . .
 Buy finished goods.  Buy raw materials.
 Sell finished goods.  Produce and sell
finished goods.

MegaLoMart
 Balance Sheet

Merchandiser Manufacturer
Current assets Current Assets
 Cash  Cash

 Receivables  Receivables
 Prepaid Expenses
 Prepaid Expenses
 Inventories
 Merchandise
Inventory Raw Materials
Work in Process
Finished Goods
 Balance Sheet

Merchandiser Manufacturer
Current assets Current Assets
 Cash  Cash

 Receivables  Receivables
Materials waiting to
 Prepaid Expenses be processed.
 Prepaid 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.
 The Income Statement

Cost of goods sold for manufacturers differs only

slightly from cost of goods sold for merchandisers.

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

Beginning
Beginning Additions
Additions Available
Available
balance
balance + $$$
$$$
= $$$$$
$$$$$
$$
$$

Available
Available _ Withdrawals
Withdrawals
Ending
Ending
$$$$$
$$$$$ $$$
$$$
= balance
balance
$$
$$
 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.
 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.
 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.
 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
Asitems
itemsare
are removed
removedfrom
fromraw
raw
in production materials
materialsinventory
inventoryandandplaced
placed into
into
the
theproduction
productionprocess,
process,they
theyare
are
called
called direct
direct materials.
materials.
 Product Cost Flows

Manufacturing Work
Raw Materials Costs In Process
Conversion
Conversion
Beginning raw Direct materials
materials inventory + Direct labor
costs
costsare
arecosts
costs
+ Raw materials + Mfg. overhead incurred
incurredtoto
purchased = Total manufacturing convert
convert the
the
= Raw materials costs
direct
directmaterial
material
available for use
in production into
intoaafinished
finished
– Ending raw materials product.
product.
inventory
= Raw materials used
in production
 Product Cost Flows

Manufacturing Work
Raw Materials Costs In Process

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
Allmanufacturing
manufacturingcosts
costsincurred
incurred
= Raw materials used during
duringthe
theperiod
periodare
areadded
addedtotothe
the
in production
beginning
beginningbalance
balanceof
of work
work in
in
process.
process.
 Product Cost Flows

Manufacturing Work
Raw Materials Costs In Process

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 work in
process inventory
Costs
Costsassociated
associatedwith
withthe
the goods
goods that
that = Cost of goods
are
arecompleted
completedduring
duringthe
theperiod
periodare
are manufactured
transferred
transferredto
tofinished
finished goods
goods
inventory.
inventory.
Product Cost Flows
 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
 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
 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
 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.
 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.
 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.
 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.
 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.
 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.
Cost Classifications for Predicting Cost
Behavior

How
How aa cost
cost will
will react
react to
to
changes
changes in in the
the level
level of
of
activity
activity within
within thethe
relevant
relevant range.
range.
 Total
Totalvariable
variablecosts
costs
change
changewhen
whenactivity
activity
changes.
changes.
 Total
Totalfixed
fixedcosts
costsremain
remain
unchanged
unchangedwhen
whenactivity
activity
changes.
changes.
 Total Variable Cost

Your total long distance telephone bill is based

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

Minutes Talked
 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
 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

 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
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.
 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.
 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.
 Assigning Costs to Cost Objects

Direct costs Indirect costs

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

• Financial reporting
• Predicting cost behavior
• Assigning costs to cost objects
• Decision making
 Idle Time

Machine Material
Breakdowns Shortages

Power
Failures

The labor costs incurred

during idle time are ordinarily
treated as manufacturing
overhead.
 Overtime

The overtime premiums for all factory

workers are usually considered to be part
of manufacturing overhead.
 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.
 Quality of Conformance

When the overwhelming majority of

products produced conform to design
specifications and are free from
defects.
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
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
 Examples of Quality Costs

Prevention Costs Appraisal Costs

• Testing & inspecting
• Quality training
incoming materials
• Quality circles
• Final product testing
• Statistical process
• Depreciation of testing
control activities
equipment

Internal Failure Costs External Failure Costs

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

When quality of conformance is low,

total quality cost is high and consists
mostly of internal and external failure.

Companies can reduce

their total quality cost by
focusing on prevention and
appraisal. The cost savings
from reduced defects
usually swamps the costs
of the additional prevention
and appraisal efforts.
 Ventura Company
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%
Downtime due to defects in quality 170,000 0.34% 100,000 0.20% of the
Disposal of defective products 500,000 1.00% 340,000 0.68%
Total internal failure cost 3,000,000 6.00% 2,000,000 4.00% company’s
External failure costs: current defect
Warranty repairs 400,000 0.80% 900,000 1.80%
Warranty replacements 870,000 1.74% 2,300,000 4.60% rate.
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%

* As a percentage of total sales. In each year sales totaled $50,000,000.

 Quality Cost Reports: 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
 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.
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.
 ISO 9000 Standards

ISO 9000 standards have become an

international measure 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.
End of Chapter 2