Principles of Accounting (II):

Management Accounting
BIZ3108

Week 2:
Cost Concepts
Jonghwan Kim, Ph.D.

Learning Objectives
1. Understand cost classifications used for assigning
costs to cost objects: direct costs and indirect costs.
2. Identify and give examples of each of the three basic
manufacturing cost categories.
3. Understand cost classifications used to prepare
financial statements: product costs and period costs.
Principles of Accounting | Prof. Jonghwan Kim

4. Understand cost classifications used to predict cost

behavior: variable costs, fixed costs, and mixed
costs.
5. Understand cost classifications used in making
decisions: relevant costs and irrelevant costs.
6. Prepare income statements for a merchandising
company using the traditional and contribution
formats.
 Cost
A sacrifice or giving up of resources for a particular purpose
- Frequently measured by the monetary units that must be
paid for goods and services.
Principles of Accounting | Prof. Jonghwan Kim

Cost Classifications

Various ways to classify costs:

• Assignment to cost object: Direct and Indirect Costs
• Business Function: Manufacturing and Non-Manufacturing
• Financial statement perspective: Product and Period Costs
• Cost behavior in relation to output: Fixed and Variable Costs
Principles of Accounting | Prof. Jonghwan Kim

• Decision-making based on differential future cash flows: Relevant

and Irrelevant
 Cost Object and Cost
Assignment
Direct vs. Indirect

Cost Object (Objective)

Anything for which decision makers desire
separate measurement of costs.

- Cost of “Something”
other than the cost of resources
e.g., departments, products, services, activities, processing
Principles of Accounting | Prof. Jonghwan Kim

orders, and territories

 Cost Accounting System
The techniques used to determine the cost of a
product, service, customer, or other cost objects.

Typically includes two processes:

1. Cost Accumulation
Principles of Accounting | Prof. Jonghwan Kim

Collecting costs by some natural classification, such

as materials or labor, or by activities performed such as
order processing or machine processing
2. Cost Assignment
Attaching costs to one or more cost objects, such as
activities, processes, departments, customers, or
products.

Accumulation and Assignment

If managers want to evaluate performance of
manufacturing departments—machining dept. and
finishing dept…
Principles of Accounting | Prof. Jonghwan Kim

Costs are accumulated for

Costs are assigned to
the use of resources.
manufacturing departments.
 Accumulation and Assignment
If managers want to measure and evaluate the efficiency
of various activities

Activity A

Activity B
Principles of Accounting | Prof. Jonghwan Kim

Activity C

Activity D

Activity E

Costs are accumulated for

Costs are assigned to
the use of resources.
manufacturing activities.

Accumulation and Assignment

If managers want to obtain costs of various products for
valuing inventory, determining income, and judging
product profitability.
Product A

Product B
Principles of Accounting | Prof. Jonghwan Kim

Product C

Product D
Costs are accumulated for
Costs are assigned to
the use of resources.
products.
 Direct and Indirect Costs
Common costs
Costs may be direct or indirect Indirect costs incurred to support
a number of cost objects. These
with respect to a particular cost object. costs cannot be traced to any
individual cost object.

Direct Costs Indirect Costs

Costs that can be identified Costs that can not be identified

Principles of Accounting | Prof. Jonghwan Kim

specifically and exclusively with a specifically and exclusively with a

given cost object in an given cost object in an
economically feasible way. economically feasible way.

Traceable Untraceable

Tracing:
Physically identifying the amount of a direct cost that relates
exclusively to a particular object.

Classifications of
Manufacturing Costs
Manufacturing vs. Nonmanufacturing
 Manufacturing Costs
Manufacturing operations transform raw materials, the
basic materials from which a product is made, into other
goods through the use of labor and factory facilities.

In manufacturing companies, products are frequently the

cost object.
Principles of Accounting | Prof. Jonghwan Kim

Direct Materials Direct Labor

Factory Overhead

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Manufacturing Costs
These costs are identified (traced/allocated) in
an economically feasible way.

Direct materials Prime Costs Direct Labor costs

include the acquisition Direct Materials Direct Labor
include the wages of all
costs labor that can be traced
of all materials that a specifically and
company identifies exclusively to the
Principles of Accounting | Prof. Jonghwan Kim

as a part of the manufactured goods.

manufactured goods.
Conversion Costs
Factory Overhead

Manufacturing overhead includes all costs associated with the production

process that the company cannot trace to the manufactured goods in an
economically feasible (not hard/useless/too costly) way.
e.g., Depreciation , property taxes, supplies, and insurance are examples of indirect costs of production.
Minor items, such as tacks or glue, and many labor costs, such as janitors and forklift operators
 Nonmanufacturing Costs
q Selling Costs
Costs necessary to secure the order and deliver the
product. Selling costs can be either direct or indirect
costs.

q Administrative Costs
Principles of Accounting | Prof. Jonghwan Kim

All executive, organizational, and clerical costs.

Administrative costs can be either direct or indirect
costs.

Classifications for
Financial Statement Preparation Purposes

Product vs. Period

 Product Costs
Costs identified with goods produced or purchased for resale
q These costs first become part of the inventory on hand,
sometimes called inventoriable costs.
- For merchandisers, they are purchase costs.
• Merchandise inventory
- For manufacturers, product costs include direct material
Principles of Accounting | Prof. Jonghwan Kim

costs, direct labor costs, and indirect production

(manufacturing overhead) costs
• Raw material inventory
• Work-in-process inventory
• Finished goods inventory
q Inventoriable costs become expenses in the form of cost of
goods sold only when the inventory is sold.

Period Costs
Costs that become expenses during the current period
without becoming part of inventory.

- These costs are accumulated by departments, such as

R&D, advertising, and sales.
- Most of these costs are reported as selling and
Principles of Accounting | Prof. Jonghwan Kim

administrative expenses.
 Merchandising Companies
Balance Sheet Income Statement

Sales

Minus

Product Expiration
Merchandise Merchandise Cost of Good Sold
(Inventoriable)
Purchases Inventory (Expense)
Costs
Principles of Accounting | Prof. Jonghwan Kim

Equals Gross Margin

Minus

Selling, General and

Period
Administrative
Costs
Expenses

Equals Operating Income

Manufacturing Companies
Balance Sheet Income Statement

Product Raw (direct) Raw (direct)

(Inventoriable) Material Material
Costs Purchases Inventory

Direct Labor Work-in- Sales

Process
Manufacturing Inventory
Minus
Principles of Accounting | Prof. Jonghwan Kim

Overhead

Finished Expiration Cost of Good Sold

Goods
(Expense)
Inventory

Equals Gross Margin

Minus

Selling, General and

Period
Administrative
Costs
Expenses

Equals Operating Income

 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.
Principles of Accounting | Prof. Jonghwan Kim

D. Electrical costs to light the production facility.

E. Sales commissions.

Classifications for
Predicting Cost Behaviors

Variable vs. Fixed vs. Mixed

 Cost Behavior
“How a cost reacts to changes in the level of
activity within the relevant range.”

• Variable Costs vary, in total, in direct

proportion to changes in the level of activity
Principles of Accounting | Prof. Jonghwan Kim

(cost-driver level).

• Fixed Costs remain constant, in total,

regardless of changes in the level of activity
(cost-driver level).

Cost Driver
A measure of activities that requires the use of resources
and thereby cause costs.

Organizations perform activities….

Principles of Accounting | Prof. Jonghwan Kim

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To produce
products
and services
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 Cost Driver
A measure of activities that requires the use of resources
and thereby cause costs.

Organizations perform activities….

Principles of Accounting | Prof. Jonghwan Kim

activities resources costs

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(Plausible) measure
$∙€
To produce
of the activities
è “Cost Driver” products
and services
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or Activity Base

Cost Behavior
Example: Watkins Products
If Watkins pays its sale personnel a 20% straight
commission on sales…

The relevant activity is…

A likely cost driver is…
Principles of Accounting | Prof. Jonghwan Kim

The total cost (if other things being equal) …

Thus, the type of cost is…

 Cost Behavior
Example: Sony
Suppose Sony rents a factory for $500,000 per year
to produce DVD players.

The relevant activity is…

A likely cost driver is…
Principles of Accounting | Prof. Jonghwan Kim

The total cost (if other things being equal) …

Thus, the type of cost is…

Fixed Costs
Numerical Example:

Cost in Total ($) 30,000 30,000 30,000

Number of units produced
1,000 2,000 3,000
(Volume of Activity)
Cost per unit ($)
Principles of Accounting | Prof. Jonghwan Kim

The TOTAL cost remains fixed at $30,000

The cost PER UNIT decreases as the output increases,
because there are more units to spread the cost (which is
fixed) over.
 Fixed Costs

Fixed costs and the volume of output / activity

Cost
($)
Principles of Accounting | Prof. Jonghwan Kim

30,000

0
Volume of activity (units of output)

Fixed Costs
Examples:
• Salary of administrative personnel (fixed monthly salary).
• Rent
• Straight line depreciation
Principles of Accounting | Prof. Jonghwan Kim
 Variable Costs
Numerical Example:

Cost in Total ($) 10,000 20,000 30,000

Number of units produced
1,000 2,000 3,000
(Volume of Activity)
Cost per unit ($)
Principles of Accounting | Prof. Jonghwan Kim

The TOTAL cost increases by $10 for each additional unit

produced.
The cost PER UNIT remains the same at $10.

Variable Costs

Variable costs and the volume of output / activity

Cost
($)
Principles of Accounting | Prof. Jonghwan Kim

0
Volume of activity (units of output)
 Variable Costs
Examples:
• The raw materials used to manufacture a unit e.g.
tomatoes for manufacturer of tomato soup
• Wages of factory workers used to produce a unit (paid
per unit)
• Commission paid to a sales representative
Principles of Accounting | Prof. Jonghwan Kim

Cost Behavior

Type In Total Per Unit

Increases
Variable in activity level Remains the same
(positive association)
Principles of Accounting | Prof. Jonghwan Kim

Decreases
Fixed Remains the same with activity level
(negative association)
 Cost Behavior

Type In Total Per Unit

Variable (1) (2)

Principles of Accounting | Prof. Jonghwan Kim

Fixed (3) (4)

(A) (B) (C)

Quick Check
Resources / Costs Type
V
1. Hamburger buns at a McDonald’s outlet V
F
2. Advertising by a KPMG office F
BAMN10632 | Fundamentals of Management Accounting | Dr. Jonghwan Kim

V
3. Apples processed and canned by Del Monte Corporation V
V
4. Shipping canned apples from a Del Monte plant to customers V
F
Principles of Accounting | Prof. Jonghwan Kim

5. Insurance on a Bausch & Lomb factory producing contact lenses F

F
6. Insurance on IBM’s corporate headquarter F
F
Salary of a supervisor overseeing production of computer boards at
7. F
Hewlett-Packard
V
8. Commissions paid to Encyclopedia Britannica salespersons V
F
9. Depreciation of factory lunchroom facilities at a ICI plant F
V
10. Steering wheels installed in BMWs V
 Mixed Costs
Some costs are neither purely fixed nor purely variable.

Mixed cost:
A cost that contains elements of both fixed- and
variable-cost behavior.
Principles of Accounting | Prof. Jonghwan Kim

= semi-variable or semi-fixed costs

e.g., In hospitals, there is a substantial fixed cost of

having expensive imaging equipment available and ready
for use. There is also a variable cost associated with
actual use of the equipment such as the costs of power,
technicians to operating the equipment, and physicians to
interpret the results.

Mixed Costs

Cost
($)
Variable
Component
Principles of Accounting | Prof. Jonghwan Kim

Fixed
Component

0
Volume of activity (units of output)
 Mixed Costs

Cost
($) Total Costs = Fixed + Variable
Variable
Component

Variable Costs
Principles of Accounting | Prof. Jonghwan Kim

Fixed
Component

Fixed Costs

0
Volume of activity (units of output)

Relevant Range
The limits of the cost-driver level within which a specific
relationship between costs and the cost driver (activity) is
valid.

Even within the relevant range, a fixed cost remains fixed

only over a given period of time—usually the budget
Principles of Accounting | Prof. Jonghwan Kim

period.
 Relevant Range
Example: General Electric
Suppose total monthly fixed costs are $100,000 for a
lightbulb plant as long as production is between 40,000
and 85,000 cases of lightbulbs per month.
è The relevant range for the fixed cost of $100,000

If production falls below 40,000 cases, changes in

Principles of Accounting | Prof. Jonghwan Kim

production processes will slash fixed costs to $60,000 per

month.

If operations rise above 85,000 cases, rentals of

additional facilities will boost fixed costs to
$115,000 per month.

Relevant Range
Example: General Electric
Suppose total monthly fixed costs are $100,000 for a
lightbulb plant as long as production is between 40,000
and 85,000 cases of lightbulbs per month.
è The relevant range for the fixed cost of $100,000

If production falls below 40,000 cases, changes in

Principles of Accounting | Prof. Jonghwan Kim

production processes will slash fixed costs to $60,000 per

month.
$115,000 -
Total Fixed Cost

100,000 -
60,000 -
If operations rise above 85,000 cases, rentals of
additional facilities will boost fixed costs to
$115,000 per month. Relevant Range

In
thousand
20 40 60 80 100 units
 Quick Check #2
Which of the following costs would be variable with
respect to the number of ice cream cones sold at a
Baskin & Robbins?
(There may be more than one correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
Principles of Accounting | Prof. Jonghwan Kim

C. The cost of ice cream.

D. The cost of napkins for customers.

Classifications for
Decision Making
Relevant vs. Irrelevant
 Relevant Costs for Decision-Making
Decision rule:

Relevant Relevant
Principles of Accounting | Prof. Jonghwan Kim

Costs Benefits

c t
je
Re
Then….RELEVANT to WHAT?

Relevant Costs for Decision-Making

Individuals and businesses often need to make decisions.

Examples of business decisions:

Should I produce product X;
Should I buy these required raw materials or make them in-
house;
Principles of Accounting | Prof. Jonghwan Kim

Should I purchase this new factory;

should I expand into Asia etc.

Does decision making relate to the FUTURE or to the

PAST?
è It relates to the FUTURE.
 Understand the Scenario
A manufacturing company…
Is considering operating its own fleet of trucks
To improve the company’s transportation operations
Principles of Accounting | Prof. Jonghwan Kim

Question:
“ Is the driver’s salary a relevant cost? ”

Identify the Relevant Cost

Scenario A Scenario B
• A company will buy a new • Assume that the decision
truck and the decision lies did not concern a choice
between two models. between two models of
• The truck will require a truck but rather whether to
operate an additional truck
Principles of Accounting | Prof. Jonghwan Kim

driver, but a suitably

qualified driver could drive or not.
either truck equally well, • QUESTION: Would the
for the same wage. driver’s wage be a
• QUESTION: Is the driver’s relevant cost?
wage a relevant cost?
 Relevant Costs or Revenues
To be RELEVANT, a cost or a revenue must meet these
conditions:

Must DIFFER from one possible decision outcome to the

next
Principles of Accounting | Prof. Jonghwan Kim

Must relate to the FUTURE

Have an effect on the wealth of the business.

(è in terms of cash flow!)

In short,
Relevance costs and benefits are “Differential Future
Cash Flows.”

Relevant Costs
Future Outlay Costs:
• Future costs that vary with the decision.

Opportunity Costs:
• The potential benefit that is given up when one alternative
is selected over another.
Principles of Accounting | Prof. Jonghwan Kim

• A measure of the benefit sacrificed when one course of

action is chosen in preference to another.
• Note that an opportunity cost is for the next-highest-
valued alternative to an action.
• Opportunity costs are implicit costs that do not appear
anywhere in the accounting records but must be
explicitly considered in every decision.
 Irrelevant Costs
Sunk Cost (=past or historic cost):
• Costs that have already been incurred. They do not
affect any future cost and cannot be changed by any
current or future action.
Principles of Accounting | Prof. Jonghwan Kim

Committed Cost:
• These are future costs that have been committed prior
to a decision point and will not change upon the decision.

Relevant vs Irrelevant Costs

Future costs that Costs that are the

vary with the same irrespective
decision under of which decision
consideration is made

Relevant Irrelevant
costs costs
Principles of Accounting | Prof. Jonghwan Kim

The cost of Costs that

being deprived Past costs were incurred
of the next best Opportunity as a result of a
(i.e. Historic
option costs costs) past decision

Those that Those that

Future outlay do not vary
vary with the Future outlay
decision costs (i.e. with the
costs decision
Committed costs)
 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?
Principles of Accounting | Prof. Jonghwan Kim

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.

Principles of Accounting | Prof. Jonghwan Kim

B. No, the licensing cost is not relevant.

 Income Statement Formats

Traditional vs. Contribution

Traditional vs. Contribution

Two formats:
Principles of Accounting | Prof. Jonghwan Kim

Used primarily for Used primarily by

external reporting management accounting
 Uses of the Contribution Format
q The contribution income statement format is used as
an internal planning and decision-making tool. We
will use this approach for:

1. Cost-volume-profit analysis (Chapter 5).

Principles of Accounting | Prof. Jonghwan Kim

2. Segmented reporting of profit data (Chapter 6).

3. Budgeting (Chapter 8).
4. Special decisions such as pricing and make-or-buy analysis
(Chapter 13).

After Class...
Recommended Problems:

q Exercises 1-[X]
o 3
o 7
Principles of Accounting | Prof. Jonghwan Kim

o 10
o 12
o 15
o 19
o 23
o 24
Principles of Accounting (II):
Management Accounting
BIZ3108

Week 2:
Cost Concepts

By Jonghwan Kim, Ph.D.