CHAPTER 2

AN INTRODUCTION TO COST TERMS AND PURPOSES

LEARNING OBJECTIVES

1. Define and illustrate a cost object

2. Distinguish between direct costs and indirect costs

3. Explain variable costs and fixed costs

4. Interpret unit costs cautiously

5. Distinguish among manufacturing companies, merchandising companies, and service-sector companies

6. Describe the three categories of inventories commonly found in manufacturing companies

7. Differentiate between inventoriable costs and period costs

8. Explain why product costs are computed in different ways for different purposes

9. Present key features of cost accounting and cost management

CHAPTER OVERVIEW

Chapter 2 provides concepts and terms, the tools for working with costs. Two basic concepts are explained:
(1) cost is a relative term and must be used in relationship to something, a cost object; and (2) common
understanding of the terms and concepts facilitates communication.

Costs are critical information in most decisions. Everything has a cost. The critical need for accurate and
reliable scorekeeping in which historical costs are properly identified and measured is underscored as decision
support. This chapter clearly defines the terms and concepts typically used in identifying costs.

As mentioned in Chapter 1, costs are ideally accumulated in a database (data warehouse or infobarn),
measured and identified with various labels. These data are assigned (slice or dice) to a specific cost object
defined for a specific purpose. Chapter 2 uses the product of a manufacturing company as an example of
cost accounting.

A good basic understanding of the terms and concepts introduced in this chapter are essential to an
understanding of the concepts contained in this text. The terms, relationships, and models developed in the
remaining chapters are built upon the definitions and explanations in this chapter. The classification of costs
in Exhibit 2-10 is most useful.
CHAPTER OUTLINE

Learning Objective 1:

Define and illustrate a cost object

I. Costs and cost terminologygeneral

TEACHING TIP: The use of jargon in the communication process can privilege a group of individuals who
understand the meaning of the terms. Jargon is used within families, companies, Greek fraternities and
sororities, clubs, professional associations, etc. Ask students to give examples of expressions or terms they
use that carry special meaning to them within a particular group. For example, a family may use the word
interesting to mean I do not like the thing in question but I am not willing to say that to you. One
company uses the term irate to indicate a particularly troublesome customer. The word carries special
meaning to those who work within that department but the customer is unaware of being so branded. The
use of menus on company telephone systems is another way of branding callersone must fit within a
given category. Cost concepts and terms are examples of jargon or branding that managers can learn to
understand for being informed through the communication process.

A. Use of cost concepts and terms to provide information

1. Able to best use information if managers understand concepts and terms

2. Facilitate communication among managers and management accountants if common

understanding

B. Definition of term cost

1. Resource sacrificed or forgone to achieve a specific objective

2. Measurement, usually a monetary amount, that must be paid to acquire goods and services

3. Use of term actual cost: cost incurred, historical, rather than budgeted or forecasted cost

C. Identification of cost object: anything for which a separate measurement of costs is needed/desired
[Exhibit 2-1]

D. Stages of accounting for costs in a costing system

1. Cost accumulation: collection of cost data in some organized means in an accounting system

2. Cost assignment: designation of cost object to aid in decision making [Exhibit 2-2]

a. Tracing accumulated costs that have a direct relationship to a cost object

b. Allocating accumulated costs that have an indirect relationship to a cost object

An Introduction to Cost Terms and Purposes 2

Do multiple choice 1. Assignmentsee fixed/variable section.

II. Costs and cost terminologyspecific

Learning Objective 2:

Distinguish between direct costs and indirect costs

A. Assignment to a cost object: accuracy important for decision making

1. Direct costs of a cost object: economically feasible to trace to cost object via cost tracing

2. Indirect costs: related to cost object but not economically feasible to trace; assigned via cost
allocation

3. Factors affecting direct/indirect classification

a. Materiality of the cost in question

b. Available information-gathering technology

c. Design of operations

d. Choice of cost object: generally the broader the definition of the cost object, the higher the
proportion of total costs that are direct costs and more confidence in cost accuracy

Do multiple choice 2. Assign Exercise 2-17.

Learning Objective 3:
Explain variable costs and fixed costs

B. Behavior pattern in relation to changes in the related level of total activity or volume

1. Costing systems: record cost of resources acquired and track how then used

2. Basic types of cost-behavior with respect to a specific cost object and given time period

a. Variable [Exhibit 2-3]

i. Changes in total in proportion to changes in the related level of total activity

ii. Use as per unit for estimates of total costs

b. Fixed [Surveys of Company Practice]

An Introduction to Cost Terms and Purposes 3

 i. Unchanged in total for a given time period despite wide changes in related level of total
activity

ii. Always focus on total costs when making cost estimates for fixed costs

3. Individual costs not inherently variable or fixed but dependent upon related activity

4. Choice of cost driver: a variable with cause-and-effect relationship between change in level of
activity and change in level of total costs [Concepts in Action]

5. Consideration of relevant range: band of normal activity level with specific relationship
between level of activity and particular cost amount [Exhibits 2-4 and 2-5]

Do multiple choice 3. Assign Exercises 2-22 and 2-23 with special emphasis on identification of
the cost object.

Learning Objective 4:

Interpret unit costs cautiously

C. Total costs and unit costs

1. Generally total cost amounts should be used in decision making

2. Some decisions need unit costs (average costs) but should be used cautiously

Do multiple choice 4. Assign Exercises 2-24 and 2-25.

III. Accounting for the cost of a product

Learning Objective 5:
Distinguish among manufacturing companies, merchandising companies, and service-sector companies

A. Product defined in three types of companies [Exhibit 2-6]

1. Manufacturing-sector companies: convert materials and components into finished good

2. Merchandising-sector companies: purchase product and sell without changing basic form

3. Service-sector companies: provide services or intangible products

Do multiple choice 5. Assign Exercises 2-18, 2-19, 2-20, and 2-27.

Learning Objective 6:
Describe the three categories of inventories commonly found in manufacturing companies

4 Chapter 2
 B. Product inventories for manufactured goods: stages in the conversion process

1. Direct materials: direct materials in stock and awaiting use in the manufacturing process

2. Work in process: goods partially worked on but not yet fully completed

3. Finished goods: goods fully completed but not yet sold

C. Product as cost object: classifications of manufacturing costs

1. Direct materials costs

2. Direct manufacturing labor costs

3. Indirect manufacturing costs, manufacturing overhead costs or factory overhead costs

Do multiple choice 6. Assign Exercises 2-28, 2-29 and 2-30, 2-36 and 2-37.

Learning Objective 7:

Differentiate between inventoriable costs and period costs

D. Product costs for financial statement placement [Exhibit 2-8]

1. Inventoriable costs: all costs of a product that are regarded as an asset (balance sheet) when
incurred and then become cost of goods sold (income statement) when product sold

a. Manufacturing company: all manufacturing costs are inventoriable costs

b. Merchandising company: costs of purchasing goods resold in their same form

c. Service company: no inventoriable costs because no inventories of product

2. Period costs: all costs in the income statement other than cost of goods sold

Do multiple choice 7 and 8. Assign Exercise 2-26.

E. Product cost reported: Schedule of cost of goods manufactured and sold [Exhibit 2-6]

1. Three categories of manufacturing costs = manufacturing costs incurred during period

a. Direct materials both as inventory and manufacturing cost

b. Direct manufacturing labor costs

c. Indirect manufacturing costs

An Introduction to Cost Terms and Purposes 5

 2. Three categories of manufacturing inventoriesstages of the conversion process

a. Direct materials used to calculate direct materials used at beginning of schedule

b. Work in process

c. Finished-goods [Exhibit 2-7]

F. Other terminology for product costs

1. Prime costs: all direct manufacturing costs

2. Conversion costs: all manufacturing costs other than direct material costs

IV. Judgment factors

A. Differences in way costs can be defined and classified [Exhibit 2-10]

1. Careful to define and understand way costs are measured in a company or situation

2. Illustrate by manufacturing labor costs

a. Detailed classification to enhance cause-effect relationship to extent possible

b. Detailed classification agreed upon to promote company-wide communication

c. Detailed classification for clarity to preclude disputes

B. Differences in uses of product cost: sum of costs assigned to a product for a specific purpose

Learning Objective 8:
Explain why product costs are computed in different ways for different purposes

1. Product cost for purpose of pricing and product-mix emphasis [Exhibit 2-9]

2. Product cost for purpose of contracting with government agencies

3. Product cost for purpose of preparing financial statements for external reporting under GAAP

Do multiple choice 9. Assign Exercise 2-33.

Learning Objective 9:
Present key features of cost accounting and cost management

V. Features of a framework for cost management

A. Calculating the costs of products, services, and other cost objects

6 Chapter 2
 B. Obtaining information for planning and control and performance evaluation

C. Analyzing the relevant information for making decisions

Do multiple choice 10. Assign Problem 2-38.

CHAPTER QUIZ SOLUTIONS: 1.a 2.d 3.a 4.b 5.b 6.c 7.d 8.a 9.b 10.a

An Introduction to Cost Terms and Purposes 7

CHAPTER QUIZ

1. Tanner Co. management desires cost information regarding their Rawhide brand. The Rawhide brand is
a(n)

a. cost object. c. cost assignment.

b. cost driver. d. actual cost.

2. The cost of replacement light bulbs on campus would be a direct cost to a college but would need to be
allocated as an indirect cost to

a. departments. c. schools.
b. buildings. d. individual student instruction.

3. What is the total fixed cost of the shipping department of EZ-Mail Clothing Co. if it has the following
information for 2002?

Salaries $800,000 75% of employees on guaranteed contracts

Packaging $400,000 depending on size of item(s) shipped
Postage $500,000 depending on weight of item(s) shipped
Rent of warehouse space $250,000 annual lease

a. $850,000 b. $900,000 c. $1,050,000 d. $1,950,000

4. Morton Graphics successfully bid on jobs printing standard notebook covers during the year using last
years price of $0.27 per cover. This amount was calculated from prior year costs, noting that no changes
in any costs had occurred from the past year to the current year. At the end of the year, the company
manager was shocked to discover that the company had suffered a loss. How could this be? she
exclaimed. We had no increases in cost and our price was the same as last year. Last year we had a
healthy income. What could explain the companys loss in income this current year?

a. Their costs were all variable costs and the amount produced and sold increased.
b. Their costs were mostly fixed costs and the amount produced this year was less than last year.
c. They used a different cost object this year than the previous year.
d. Their costs last year were actual costs but they used budgeted costs to make their bids.

5. Which type of company does not have inventoriable costs?

a. Not-for-profit c. Merchandising
b. Service d. Manufacturing

6. The three categories of inventories commonly found in many manufacturing companies are

a. direct materials, direct labor, and indirect manufacturing costs.

b. purchased goods, period costs, and cost of goods sold.
c. direct materials, work-in-process, and finished-goods.

8 Chapter 2
 d. LIFO, FIFO, and weighted average.

7. Inventoriable costs are

a. either finished goods or purchased goods for resale.

b. a category of costs used only for manufacturing companies.
c. recorded as expenses when incurred and later reclassified as assets.
d. recorded as assets when incurred.

8. Period costs are

a. all costs in the income statement other than cost of goods sold.
b. defined as manufacturing costs incurred this period on the schedule of cost of goods manufactured.
c. always recorded as assets when first incurred.
d. those costs that benefit future periods.

9. The cost of a product can be measured as any of the following except as cost

a. gathered from all areas of the value chain.

b. identified as period cost.
c. designated as manufacturing cost only.
d. explicitly defined by contract.

10. The primary focus of cost management is to

a. help managers make different decisions.

b. calculate product costs.
c. aid managers in budgeting.
d. distinguish between relevant and irrelevant information.

An Introduction to Cost Terms and Purposes 9

WRITING/DISCUSSION EXERCISES
1. Define and illustrate a cost object

Describe and give an example of cost other than one with a conventional meaning (cash
outlay). Everything has a cost. Not all costs are evident or can they be identified and measured in a more
conventional manner but they are costs nevertheless.

Some costs are named but not accounted for in the traditional sense. One example is opportunity cost
[defined in text at later point] that can be associated with any cost object. Though financial amounts may be
associated with this cost, they do not appear in the accounting records.

Human costs are another example of costs that may be associated with most cost objects. The text
emphasizes the importance of using a management accounting system to help individuals do their jobs better.
Sometimes companies engage in cost management that benefits the company by costing their employees (and
society) on a personal basis. The use of some types of chemicals can result in more efficient processing but
they may have detrimental effects on the health of those who use them as prescribed by the company. The
manner in which the butter flavoring for microwave popcorn is applied may be such an example.

Until recently, unused capacity was not identified as a cost. In a later chapter costs are attached to this
situation and cost objects identified.

2. Distinguish between direct costs and indirect costs

What is so important about the way in which costs are categorized? In their book, Sorting
Things Out: Classification and Its Consequences, Geoffrey Bowker and Susan Star describe the constant
activity of labeling and sorting of all that we have and do in life. They note that not all classifying is formal
or even noticed by us. For those formal classification systems we can usually find some gaps in the system
and are unable to assign everything to a specific category. The example is given of disease classifications for
medical records. We do not have perfect knowledge of all diseases and the interaction of various ailments
yet a category must be picked. Shakespeares Whats in a name: That which we call a rose by any other
name would smell as sweet (Romeo and Juliet) may not be so poetic when something or someone is
mistakenly assigned to what is perceived as an undesirable category (student grades, for example). In
studying the classification of costs, consideration should be given to such problems as imperfect knowledge,
inaccurate description, and simplistic classification systems. These do not negate the usefulness of the present
classification system but can be used to inform it, especially when critical decisions are being made on the
basis of that present system.

Bowker, George & Star, Susan. 1999. Sorting Things Out: Classification and Its Consequences. Cambridge MA: MIT
Press
3.

10 Chapter 2
Explain variable costs and fixed costs

How can a cost driver/cost relationship be developed? The development of a relationship is similar
to that of developing a working model (often labeled the scientific method). Thoughtful observation is
primary. As one observes recorded data, both financial and nonfinancial, noting relevant changes in related
factors, causal relationships can be inferred. From the inferences, assessment can be made about the
plausibility of such a cause-effect relationship.

Most relationships are complex and all of the interrelationships cannot be discerned, therefore a model cannot
be as accurate and reliable as the actual relationship. Models must be simplistic in order to be useful (cost-
benefit approach). They must also be updated from time to time or cast off for a new approach as things
change. Models can be relied upon to eliminate some errors that could occur without their use. If a model is
used like a checklist then inexperienced workers can be productive more quickly by following an
experience model before they gain complete understanding. Artificial intelligence is based upon human
models of thinking about a particular task. In the example of filling out income tax returns, the model gave
right answers more often than the professionals did because the professionals sometimes forget to include a
minor item or consideration.

4. Interpret unit costs cautiously

Explain why a variable cost stays the same per unit and a fixed cost changes per unit.
Which cost would decision makers prefer to use as a per unit cost and why? In calculating a
per unit cost, division is used. Variable costs derive the name variable from their total cost behavior. As the
numerator changes (the cost), the denominator (the cost driver) also changes in proportion so that the quotient
is the same at any level within the relevant range. A fixed cost, however, means that the numerator is fixed in
total within the relevant range. As the denominator changes, the numerator does not, and the resulting
quotient changes with each change in the denominator. The name of the cost is based upon total cost behavior
and does not apply to per unit cost behavior, but in fact, the unit behavior can be described as the opposite of
how the total behavior is described.

Most decision makers would do well to use only variable costs on a per unit basis. Decisions are about the
future, and in predicting costs, one would want to use a cost for which the behavior was more easily
predictable. Fixed costs can be predicted more accurately in total. To use them as unit costs, one would have
to carefully predict a level of activity for the cost driver. If another activity level were to be considered, the
per unit cost would have to be recalculated; whereas for the variable cost, several levels of activity could be
used without recalculating the per unit cost (relevant range concept).

5. Distinguish among manufacturing companies, merchandising companies, and service-sector

companies

Why would a service-sector company need cost accounting when it does not have product
inventories or cost of goods sold? Service-sector companies do have products and need to know if the
revenues generated by those products or services exceed the cost of furnishing the service. For financial
accounting the service cannot be inventoried because it does not exist until it is performed, at which time it
becomes an expense. The expense is not labeled cost of goods sold because it is not a good in the
traditional meaning. Cost accounting is more than costing a product that can be inventoried. Costs must be
accumulated and assigned for service-sector companies. The greater context of cost management is also
important for service-sector companies.

An Introduction to Cost Terms and Purposes 11

6. Describe the three categories of inventories commonly found in manufacturing companies

What effect, if any, does having a two-part classification of manufacturing costs (Direct
materials and Manufacturing overhead) rather than a three-part classification of
manufacturing costs (Direct materials, Direct manufacturing labor, and Manufacturing
overhead) have on the categories of inventories commonly found in manufacturing
companies? Could classifications of manufacturing costs be changed such as to affect the
inventory categories? In general, the number of classifications of manufacturing costs does not affect the
categories of inventories. The amount of the cost may be somewhat changed in that a more detailed
classification could result in more accurate costing, though be more expensive to maintain. The specific
change of a three-part to a two-part classification system as noted in the text does no more than reclassify the
labor cost from direct to indirect. If labor constitutes less cost due to changes in the manufacturing process, a
change from a three-part to a two-part is clearly justified.

Changes resulting from just-in-time or throughput costing may indeed change the inventory categories by
eliminating the work in process category, for example. With just-in-time costing, a two-part classification of
costs may be used. The two-part classification could be raw and in-process and finished goods
necessitating only those two inventories rather than the typical three.

7. Differentiate between inventoriable costs and period costs.

Using the value chain concept of business functions explain why costs preceding the
function of production are not considered inventoriable costs for external financial
statements. The definition of an asset, of which inventory is one, is the right to future benefit. A product
that can be sold for more than it cost promises future benefit, thus inventory is classified as an asset. The cost
of research and development as well as design may indeed impart future benefit, but such benefit is difficult
to measure. Generally accepted accounting principles would expense those costs rather than capitalize them
(classified as assets).

8. Explain why product costs are computed in different ways for different purposes

If costs can be assigned in different ways for different purposes, how does one know what
costs to combine? The purpose for which costs are to be developed must be clearly defined. From that
clear purpose, a cost object can be identified so costs can then be appropriately assigned. In the situations in
which the cost object may be defined commonly as the product cost but for which differing amounts of the
same costs are assigned, one can look more closely at the particular purposes. The cost object, though
appearing to be the same product in various situations, is not. For purposes of pricing, the product must
cover all costs of the organization for that is the means by which the company would earn a profit. For
purposes of costing the product for a specific contract, the terms of the contract would have to be met. For
financial accounting purposes, the cost of the product would have to meet the definition given under GAAP.
Using a common label for a cost object such as product cost is not enough to define the combining of cost
but one must look to the particular purpose and its full meaning.

9. Present key features of cost accounting and cost management

What is the reason for incurring costs? Costs eventually become expenses that are then matched to
the revenues they generate for calculating income. The primary reason for any expense is to generate
revenue.

12 Chapter 2
 BEWARE OF UNIT COSTS

Tot Uni
al t
Variable Vari Sam
es e
Fixed Fix Chan
ed ges

DANGER ZONE
for using unit
costs

An Introduction to Cost Terms and Purposes 13

Schedule of Cost of Goods Manufactured and Sold

Beginning direct materials inventory

+ Purchases
Available for use
Ending direct materials inventory
Direct materials used
Direct manufacturing labor
Indirect manufacturing costs (Listing)
Variable

Fixed

Total
Manufacturing costs incurred during current period
+ Beginning work-in-process inventory
Total manufacturing costs to account for
Ending work-in-process inventory
Cost of goods manufactured
+ Beginning finished goods inventory
Goods available for sale
Ending finished goods inventory
Cost of goods sold (to income statement)

Income Statement
Revenue (Sales)
Cost of goods sold (from schedule)
Gross margin
Operating costs
Operating income

14 Chapter 2
SUGGESTED READINGS

Bowker, G. & Star, S., Sorting Things Out: Classification and Its Consequences (1999) MIT Press,
Cambridge MA.

Brierley, J., Cowton, C. & Drury, C., How Product Costs Are Calculated and Used in Decision Making: A
Pilot Study, Managerial Auditing Journal (April 2001) p.202 [5p].

Gordon, L. and Loeb, M., Distinguishing between Direct and Indirect Costs Is Crucial for Internet
Companies, Management Accounting Quarterly (Summer 2001) p.12 [6p].

Hull, G., Whats in a Label? Complicating Notions of the Skills-Poor Worker, Written Communication
(October 1999) p.379 [34p].

An Introduction to Cost Terms and Purposes 15