2 - Cost Concepts and Behavior

CHAPTER TWO: COST CONCEPTS AND BEHAVIOR
 A cost is a sacrifice of resources. Its two major categories are:

o Outlay cost- past, present, or future cash outflow
o Opportunity cost- forgone benefit which would have been realized from the best forgone alternative use of a
resource
 An expense is a cost charged against revenue in an accounting period.
 Accounting systems typically record outlay costs but not opportunity costs. A well-designed cost accounting system
presents all relevant information to managers, including opportunity costs that they may otherwise ignore in decision
making.
 Operating profit is the excess of operating revenues over the operating costs incurred to generate those revenues.
 Net income is operating profit adjusted for interest, income taxes, extraordinary items, and other adjustments.
 Information from cost accounting are just means to an end, the final products are managerial decisions and actions
(change in firm value) that result from the information generated by the system.
Service Organizations
 The line-item cost of services sold include the cost of billable hours
(hours billed to clients) plus the cost of other items billed to clients
(charges for performing an information search or printing costs).
Costs that are not part of the services billable to clients are included in
the marketing and administrative costs.
 The gross margin reflects the ability to price the products, while the
marketing and administrative costs reflect relative efficiency in
operating the business itself.
Merchandising Organizations
 The income statement for these companies include revenue and
cost items and has an added category of cost information called
cost of goods sold to track the cost of goods they buy and sell.
 Cost of goods sold include only the actual costs of the goods that
were sold.
Manufacturing Organizations
 For decision making, it is not enough to know how much we paid for a good, we must also know the different costs
associated with it.
 Product costs (manufacturing costs) are costs assigned to units of production and recognized (expensed) when the
product is sold.
o Direct manufacturing costs are those that can be identified with units (or batches of units) at relatively low cost.
 Direct materials (raw materials) can be feasibly identified directly, at relatively low cost.
 Direct labor of workers which can be identified directly, at reasonable cost, with the product.
 Manufacturing overhead are all other costs of transforming the material into a finished product.
a. Indirect labor are cost of workers who do not work directly on the product yet are required so that the factory
can operate
b. Indirect materials are not part of the finished product but are necessary to manufacture it.
c. Other manufacturing costs such as depreciation, taxes, insurance, and similar expenses to keep the factory
operating.
o Indirect manufacturing costs are all other costs.
 Prime costs are direct costs, namely direct materials and direct labor.
 Conversion costs are the costs to convert direct materials into the final product.
 Period costs (nonmanufacturing costs) include all other costs and are expensed as they are incurred.
o Marketing costs are the costs required to obtain customer orders and provide customers with finished products.
o Administrative costs are the costs required to manage the organization and provide staff support.
 The process of assigning costs is called cost allocation.

 A cost object is any end to which the cost is assigned.
 Costs in the cost pool are the costs we want to assign to the cost objects. The cost allocation rule is the method or
process used to assign the costs in the cost pool to the cost object
 Any cost that can be unambiguously related to a cost object is a direct cost of that object. Those that cannot be
unambiguously related to a cost object are indirect costs.
 Costs added to inventory accounts are inventoriable costs.
Cost Behavior
 Cost behavior deals with the way costs respond to changes in activity levels.
 Fixed costs remain unchanged as the volume of the activity changes and variable costs change in direct proportion to
the change in volume activity.
 The identification of a cost as fixed or variable is valid only within a certain range of activity. This range within which
the total fixed costs and unit variable costs do not change is called relevant range.
 A semivariable cost (mixed cost) has both fixed and variable components. It is fixed at a certain range, and when it
exceeds that range has an added variable cost for every increase.
 Semifixed costs (step costs) increase in steps.
 Four aspects of cost behavior complicate the task of classifying costs into fixed or variable categories.
1. Not all costs are strictly fixed or variable.
2. Some costs increase with volume in steps.
3. Cost relations are valid only within a relevant range of activity.
4. The classification of costs as fixed or variable depends on the measure of activity used.
 Full cost is the sum of all cost of manufacturing and selling a product. It includes both fixed and variable costs.
 Full absorption costs are all variable and fixed manufacturing costs used to compute a product’s inventory value under
GAAP.
 Gross margin is revenue less costs of goods sold. Per unit, gross margin is calculated as selling price less full
absorption cost per unit.
 Contribution margin is the difference between the sales price and the variable cost per unit.
 Three common approaches on the determination of product costs are:

a. Full absorption costing (traditional income statement)- Under this approach required by GAAP, all fixed and
variable manufacturing costs are product costs. All other costs are period costs.
b. Variable costing (contribution margin income statement)- Only variable manufacturing costs are product costs, all
others are period costs.
c. Managerial costing- This approach assumes that management determines which costs are associated with the
product and should be considered product costs.
Discussion
 Profit margin is after all costs considered including marketing and administrative expenses, while gross margin is
after cost of goods sold.
 Operating profit and profit margin are the same, gross profit and gross margin are also the same.

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2 - Cost Concepts and Behavior

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CHAPTER TWO: COST CONCEPTS AND BEHAVIOR

 A cost is a sacrifice of resources. Its two major categories are:

 The process of assigning costs is called cost allocation.

 Three common approaches on the determination of product costs are:

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