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Cost Behavior and Cost Objects

Classifying a cost is based on its behavior over a relevant range. Fixed and variable costs
are defined with respect to specific cost drivers for a specific duration of time.

Variable cost measured on a per-unit basis will remain constant over a relevant range (such
as $5/unit within a relevant range of 1 to 5,000 units). Direct materials and direct labor are
both variable costs because more materials and labor are needed if more units of a product
are produced.

Fixed costs are the portion of the total cost that do not change when the quantity of a cost
driver changes over a relevant range and duration. Step costs are fixed costs with a narrow
relevant range fixed over the short run but variable over the long run.

Fixed costs may be discretionary costs, such as advertising or training, or committed costs,
such as depreciation on equipment previously purchased. Committed fixed costs tend to be
facilities-related and result from prior capacity-related decisions.

The figure below shows both fixed and variable costs over a relevant range.

Step Costs

Step costs are fixed costs with very narrow relevant ranges. Step costs tend to be
considered fixed costs over the short run, but become variable costs over the long run.

The narrow relevant ranges on step costs can be step-fixed or step-variable.

Step-fixed ranges increase in equal-sized chunks over an equal number of cost drivers;
such as, plant overhead increasing by $100,000 for each plant added. The graph on the left
below provides a graphical depiction of the behavior of step-fixed costs.
Step-variable ranges go up to a higher constant cost in either increasingly larger or
increasingly smaller amounts of a cost driver. Step-variable costs can increase or decrease
at a predictable rate when they are caused by factors such as increasing learning curve
rates for workers, diminishing marginal returns, or economies of scale. For example, if one
worker can produce 0.5 units per day, two workers can produce 1.0 unit, three workers can
produce 1.5 units and 4 workers can produce 3.0 units, the resulting step-variable cost
graph would look like those on the right above.


Capacity relates to relevant range, because when the capacity limits are reached, this is
often the upper limit of the relevant range. Furthermore, as capacity limits are approached,
operations lose efficiency and are subject to increased costs. Capacity decisions made in
the past will generally determine a companys present fixed costs.

In analyzing costs, capacity may be defined as practical or theoretical. When output

exceeds the practical capacity, marginal costs begin to exceed marginal benefits.

When capacity is defined by the expected demand for output or budgeted demand, it is
called capacity utilization. Normal capacity utilization will meet the average customer
demand over a period of several years, including the seasonal and cyclical variations or
trends. Master budget capacity utilization is normal capacity utilization for the current budget
period, such as a year. Each of these capacity levels can be used to allocate costs, and
each will generally show a different amount.

Cost Drivers

There are four types of cost drivers:

Activity-based cost drivers focus on operations that involve manufacturing or

service activity such as machine setup, machine use, or packaging.

Volume-based cost drivers focus on output, which involves aggregate measures

such as units produced or labor hours.

Structural cost drivers focus on company strategy, which involves long-term plans
for scale, complexity, amount of experience in an area, or level of technical

Executional cost drivers focus on short-term operations, which involve reducing

costs through concern with workforce commitment and involvement, production
design, and supplier relationships.

Actual, Normal, and Standard Costing

Cost allocation is a method of applying costs to products, jobs, or services.

Actual costing - material, labor, and overhead are charged at actual cost.

Normal costing - materials and labor are charged at actual cost; overhead is
charged using a predetermined rate

Standard costing - expected or target costs used for material, labor, and overhead

Actual costing is not widely used because actual overhead costs are generally not available

Normal costing allows current calculation of product costs and, by normalizing the
fluctuations in overhead rates, enables comparisons between periods.

Standard costing is designed to point out where variances occur so that the company can
achieve a better operating result.

Normal Costing

Normal costing uses predetermined overhead rates that are developed by:
1. Creating an annual (or other period) budget for overhead costs.
2. Choosing cost drivers (usually activity or volume) for charging overhead.
3. Estimating the total annual amount or volume (of the selected cost driver) for the total
overhead costs or each cost pool.
4. Calculating the predetermined factory overhead rate by dividing the budgeted factory
overhead costs by the estimated cost driver activity level.

Cost drivers can be based on direct labor hours, machine hours, units of product, or direct
labor dollars. Overhead is allocated (or applied) to products and services based on actual
cost driver quantity.

Factory overhead using normal costing will be underapplied in some months and
overapplied in others. The net amount overapplied is the amount of applied overhead that
exceeds actual costs, and vice versa. Overhead variances need to be closed out at the end
of the period (at least annually).

The net amount over- or underapplied is disposed of either by adjusting the cost of goods
sold account or by prorating the net difference between the current periods applied
overhead balances in the work-in-process inventory, finished goods inventory, and cost of
goods sold accounts. Materiality thresholds determine whether to adjust the cost of goods
sold account or to prorate the difference among the inventory accounts.

Standard Costs

Each standard cost is usually broken down into:

A standard number of units of a cost driver adjusted for actual unit production.

A standard rate per unit of the cost driver

Standard costs, such as standard number of hours times the standard rate per hour, can
then be compared to actual total costs, such as total direct labor costs. These differences
between standard costs and actual costs lead to budget variances.

Advantages of standard costs are that they are less likely to incorporate past inefficiencies
and can be adapted as new data indicates expected changes during the budget period. The
disadvantage in standard costing relates principally to the use of unreasonable or poorly
communicated standards.

Absorption (Full) and Variable (Direct) Costing

Absorption costing (or full costing) is an inventory costing system that includes both variable
and fixed manufacturing costs. Under absorption costing, inventory absorbs all costs of
manufacturing. Variable costing (or direct costing) is an inventory costing method that
includes only the variable manufacturing costs in the inventory costs and excludes fixed
manufacturing costs.

Each method expenses all nonmanufacturing costs (both fixed and variable) in the period in
which they occur. However, variable costing also expenses fixed manufacturing costs in the
period in which the costs are incurred.

Benefits and Limitations of Absorption and Variable Costing

When inventory increases, net income under absorption costing will be greater than under
variable costing by the amount of the fixed cost of the change in inventory. When inventory
decreases, net income under absorption costing will be less than under variable costing by
the amount of the change in inventory fixed cost. The differences between variable and
absorption costing will grow less material as methods such as just-in-time production and
other inventory reduction methods increase in importance because inventory levels are less

Absorption costing is required by both the U.S. Internal Revenue Service and GAAP.

However, absorption costing does enable managers to manipulate operating income simply
by increasing production or by producing items that absorb the highest fixed manufacturing

Variable costing is used when the emphasis is on what items can be traced to and
controlled by a responsibility center. The method is very effective in supporting internal
decision making and is required for cost-volume-profit analysis.

Joint Product and By-Product Costing

A manufacturing process can produce several products from the same materials. Joint
products are products that share a portion of the production process and have relatively the
same sales value. By-products share a production process but have a relatively minor value
compared to the principal product.

Joint costs are those costs incurred up to split-off point, when separate processing of the
products begins.

Costing for joint products and by-products includes all manufacturing costs incurred before
and after the split-off point. For financial reporting, joint costs incurred before the split-off
point are allocated among the joint products. Additional processing costs (separable costs)
are any costs that can be specifically identified with a product because the cost occurs after
the split-off point.

Allocating Joint Costs

There are two general approaches to allocating joint costs. The choice of approach
depends on the availability of external market information. GAAP requires joint costs to be
allocated, but is not specific about the method used.

Market-based methods

Sales value at split-off method Simple to calculate and allocates costs

according to the value of the products, but not useful for products that need
additional processing after the split-off point before a sales value is established

Gross profit method Allocates both joint costs and total gross margin to a
joint product to maintain a constant gross margin for each joint product

Net realizable value (NRV) method Allocates values in proportion to the value
of the product and produces predictable profit margins; used when the market
price for one or more of the joint products cannot be determined at the split-off
point, usually because additional processing is needed.

Physical unit method Allocates joint costs based on a products physical units
produced, but does not allocate costs according to value and therefore can
sometimes allocate so much cost to a product that it has no gross profit margin
whereas its counterpart joint product has a huge profit margin. Does not comply with

Accounting Treatment of Joint Products and By-Products

Joint product costs, once allocated, become part of inventory costs and are divided among
the various finished goods. According to GAAP, all joint costs that can be considered
manufacturing costs should be allocated to joint products for purposes of financial reporting
and taxation.

By-products can be accounted for by asset recognition or revenue method.

Asset recognition: Used if firm can assign an inventoriable value to by-products at the
split-off point. In the period in which the by-product is produced, it can either

Record the net realizable value of the by-products as inventory on the balance sheet
and as a deduction from the total manufacturing cost on the income statement

Record the NRV of the by-products as other income (or other sales revenue item) on
the income statement

When by-product is sold, the inventory cost is recorded as the cost of sales.

Revenue method: Used if the firm cannot assign an inventoriable value to by-products at
the split-off point. It can:

Record the net sales revenue from a by-product as other income (or other sales
revenue item) on the income statement.

At the time of sale, record the net sales revenue as a reduction of the total
manufacturing cost on the income statement.

The revenue methods are simpler to use and are based on the concepts of revenue
realization but should be reserved for immaterial amounts.

Topic 2:

Job Order versus Process Costing

Two basic types of costing systems are used in assigning costs to products or services: job
order costing andprocess costing.
Job Order Costing
Used when the product or service has costs that
can be tracked and assigned to a specific job or

Process Costing
Used for multiple, nearly identical units that can be
organized into a flow

Costs accumulated by job

Costs accumulated by department

Computes unit cost by job at the end of the job

Computes cost at end of the accounting period,

after total department costs are available

Gives a detailed breakdown of all of the different

types of costs; gross margin and gross profit
margin can be used to compare the companys
profitability across different jobs

Allocates costs to specific departments, enabling

individual managers to control their own cost

Examples: research and development, custom

housing construction, and consulting projects.

Examples: soft drink production, check

processing, and newspaper printing.

Job Order Costing

The basic steps in using job costing to assign costs to a job are:
1. Identify the job.
2. Trace the direct costs for the job (direct materials, direct labor).
3. Identify indirect cost pools associated with the job (overhead).
4. Select the cost allocation base (cost drivers) to be used in allocating indirect cost pools to
the job.

5. Calculate the rate per unit of each cost allocation base. The actual indirect cost rate is
calculated as:

6. Assign cost to the cost object by adding all direct costs and indirect costs.