Chapter 2

Lecture Notes

Chapter theme: This chapter explains how managers

need to rely upon different classifications of costs for
different purposes. The four main purposes emphasized in
1 this chapter include preparing external financial
reports, predicting cost behavior, assigning costs to
cost objects, and making business decisions.

I. General cost classifications: Our initial focus is on

manufacturing companies since their basic activities
include most of the activities found in other types of
business organizations. Nonetheless, many of the concepts
developed in this chapter apply to diverse organizations.

Learning Objective 1: Identify and give examples of

2 each of the three basic manufacturing cost categories.

A. Classifications of manufacturing costs (e.g., direct

3 materials, direct labor, and manufacturing overhead):

i. Direct materials  Raw materials that

become an integral part of the finished
4 product and whose costs can be conveniently
traced to it.

ii. Direct labor  Labor costs that can be easily

5 traced to individual units of product (also
called touch labor).

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 iii. Manufacturing overhead  Includes all
manufacturing costs except direct materials
and direct labor. These costs cannot be easily
traced to specific units produced (also called
indirect manufacturing cost, factory overhead,
and factory burden).

1. Includes indirect materials that are part of

the finished product, but that cannot be
6 easily traced to it.
2. Includes indirect labor costs that cannot be
conveniently traced to the creation of
products.
3. Other examples of manufacturing overhead
include: maintenance and repairs on
production equipment, heat and light,
property taxes, depreciation and insurance
on manufacturing facilities, etc.

Helpful Hint: Use something in the classroom such as a

chair to illustrate manufacturing cost concepts. Center
discussion on the raw materials classified as direct
materials and as manufacturing overhead; labor costs
classified as direct labor and as manufacturing
overhead; and other costs incurred to produce the
chair that are classified as manufacturing overhead.

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 B. Classifications of nonmanufacturing costs (also
called selling and administrative costs).

i. Selling costs – Includes all costs necessary to

secure customer orders and get the finished
product into the hands of the customer.
7
ii. Administrative costs – Includes all costs
associated with the general management of an
organization.

Learning Objective 2: Understand cost classifications

8 used to prepare financial statements: product costs and
period costs.

C. Product costs versus period costs

i. Product costs (also called inventoriable

costs) – Includes all the costs that are
involved in acquiring or making a product.
More specifically, it includes direct materials,
direct labor, and manufacturing overhead.
9 1. Product costs are expensed in the income
statement when the products are sold.

ii. Period costs – Includes all marketing or

selling costs and administrative costs.

1. These costs are expensed in the income

statement in the period incurred.

10-11 Quick Check  product versus period costs

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 D. Prime costs and conversion costs

i. Prime cost  Direct materials cost plus direct

labor cost.
12
ii. Conversion cost – Direct labor cost plus
manufacturing overhead costs.

II. Cost classifications on financial statements

A. Merchandising vs. manufacturing companies

i. Merchandising companies  Purchase

finished goods from suppliers for resale to
13 customers.

ii. Manufacturing companies  Purchase raw

materials from suppliers and produce and sell
finished goods to customers.

B. The balance sheet: merchandising vs.

manufacturing companies

i. Merchandising companies do not have to

distinguish between raw materials, work in
14 process, and finished goods. They report one
inventory number on their balance sheet
labeled merchandise inventory.

ii. Manufacturing companies report three types

of inventory in one consolidated number on
their balance sheets.
1.

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 Raw materials – The materials used to make the product.
2. Work in process − Consists of units of
product that are partially complete, but will
15 require further work to be saleable to
customers.
3. Finished goods − Consists of units of
product that have been completed, but not
yet sold to customers.

Learning Objective 3: Prepare an income statement

16 including calculation of the cost of goods sold.

C. The income statement: merchandising vs.

manufacturing companies

i. Merchandising companies calculate cost of

goods sold as:

17 COGS = BMI + Purchases – EMI

ii. Manufacturing companies calculate cost of

goods sold as:

COGS = BFGI + COGM – EFGI

Helpful Hint: Before proceeding, enhance students’

understanding by explaining that the raw materials, work
in process, and finished goods inventories all follow the
same logic. They start out with some beginning inventory.
18 Additions are made during the period. At the end of the
period, everything that started in the inventory or that was
added must either be in the ending inventory or have been
transferred out to another inventory account or to cost of
goods sold.
19-20 Quick Check  inventory flows
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 Learning Objective 4: Prepare a schedule of cost of
21 goods manufactured.

D. The schedule of cost of goods manufactured

i. This schedule contains the three elements of

costs mentioned previously, namely direct
materials, direct labor, and manufacturing
overhead.
22 ii. It calculates the cost of raw material, direct
labor, and manufacturing overhead used in
production.

iii. It calculates the manufacturing costs

associated with goods that were finished
during the period.

E. Product cost flows

i. To create a schedule of cost of goods

manufactured, as well as a balance sheet and
income statement, it is important to
understand the flow of product costs:

1. Raw material purchases made during the

23 period are added to beginning raw materials
inventory. The ending raw materials
inventory is deducted to arrive at the raw
materials used in production.
a. As items are removed from raw
materials inventory and placed into the
production process, they are called
direct materials.

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 23
2. Direct labor and manufacturing overhead
(also called conversion costs) used in
24
production are added to direct materials to
arrive at total manufacturing costs.
3. Total manufacturing costs are added to the
25 beginning work in process to arrive at total
work in process.
4. The ending work in process inventory is
deducted from the total work in process for
26 the period to arrive at the cost of goods
manufactured.
5. The cost of goods manufactured is added to
the beginning finished goods inventory to
arrive at cost of goods available for sale.
27
The ending finished goods inventory is
deducted from this figure to arrive at cost of
goods sold.
6. All raw materials, work in process, and
unsold finished goods at the end of the
period are shown as inventoriable costs in
the asset section of the balance sheet.
7. As finished goods are sold, their costs are
transferred to cost of goods sold in the
28 income statement.
8. Selling and administrative expenses are not
involved in making the product; therefore,
they are treated as period costs and reported
in the income statement for the period the
cost is incurred.

29-36 Quick Check  product cost flows

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 III. Cost classifications for predicting cost behavior

Learning Objective 5: Understand cost classifications

37 used to predict cost behavior: variable costs and fixed
costs.

A. Cost behavior refers to how a cost will react to

changes in the level of activity within the relevant
A. range. The most commonly used classifications of cost
behavior are variable and fixed costs:

i. Variable cost  A cost that varies, in total, in

direct proportion to changes in the level of
39-40
activity. However, variable cost per unit is
constant.

ii. Fixed cost  A cost that remains constant, in

total, regardless of changes in the level of the
41-42 activity. However, if expressed on a per unit
basis, the average fixed cost per unit varies
inversely with changes in activity.

iii.
It is helpful to think about variable and fixed
43 cost behavior in a 2x2 matrix.
Helpful Hint: To illustrate fixed costs, ask students for
the cost of a large pizza. Then ask: What would be the
cost per student if two students buy a pizza? What if
four students buy a pizza? This makes it clear why
average fixed costs change on a per unit basis. To
illustrate variable costs, add that a beverage costs $1
and each student eating the pizza has one beverage. So,
if two people were eating the pizza, the total beverage
bill would come to $2; if four people, $4. The cost per
beverage remains the same, but the total cost depends
on the number of people ordering a beverage.
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44-45 Quick Check – variable vs. fixed costs

IV. Cost classifications for assigning costs to cost objects

Learning Objective 6: Understand cost classifications

46 used for assigning costs to cost objects: direct costs
and indirect costs.

A. Cost object  Anything for which cost data are desired

including products, customers, jobs, organizational
subunits, etc. For purposes of assigning costs to cost
objects costs are classified two ways:

i. Direct costs  Costs that can be easily and

conveniently traced to a specified cost object.
47
ii. Indirect costs  Costs that cannot be easily
and conveniently traced to a specified cost
object.

1. Common costs  Indirect costs incurred to

support a number of cost objects. These
costs cannot be traced to any individual cost
object.

V. Cost classifications for decision making

Learning Objective 7: Understand cost classifications

48 used in making decisions: differential costs,
opportunity costs, and sunk costs.

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 A. It is important to realize that every decision involves a
choice between at least two alternatives. The goal of
B. making decisions is to identify those costs that are
either relevant or irrelevant to the decision. To make
decisions, it is essential to have a grasp on three
49 concepts:

i. Differential costs (or incremental costs)  A

difference in cost between any two
alternatives (a difference in revenue between
two alternatives is called differential
50 revenue).

1. Differential costs can be either fixed or

variable.

ii. Opportunity cost  The potential benefit that

is given up when one alternative is selected
over another.

51 1. These costs are not usually entered into the

accounting records of an organization, but
must be explicitly considered in all
decisions.

Helpful Hint: Ask students what opportunity costs they

incur by attending class. Their opportunity cost is the
value to them of the activity they would be doing
otherwise (e.g., working, sleeping, partying, studying,
etc.)

iii. Sunk cost  A cost that has already been

52 incurred and that cannot be changed now or in
the future.

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 Helpful Hint: Ask students: “Suppose you had
purchased gold for $400 an ounce, but now it is selling
for $250 an ounce. Should you wait for the gold to
reach $400 an ounce before selling it?” Many students
will say “yes” even though the $400 purchase is a sunk
cost.

53-58 Quick Check  relevant costs

VI. Summary of the types of cost classifications

A. We have looked at the cost classifications used for

financial reporting, predicting cost behavior,
C. assigning costs to cost objects, and making business
decisions.

VII. Appendix 2A: further classification of labor costs (Slide

#60 is the title slide)

Learning Objective 8: Properly account for labor costs

61
associated with idle time, overtime, and fringe benefits.

A. Accounting for idle time, overtime, and fringe benefits

i. Idle time  Machine breakdowns, material

shortages, power failures and the like, result
in idle time. The labor costs incurred during
62 idle time are ordinarily treated as
manufacturing overhead. This spreads the
costs across all the production rather than the
units in process when the disruptions occur.

ii. Overtime  The overtime premiums for all

factory workers are usually considered to be
part of manufacturing overhead. This is done
63
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 to avoid penalizing particular products or
customer orders simply because they happen
to fall on the tail end of the daily production
schedule.

 Exceptions may be found in some Asian

companies which consistently have
overtime due to the urge of full utilization
63 of available capacity and shortage of
workers. In those cases, they may have
valid arguments to put overtime as part of
the normal labor cost.

iii. Labor fringe benefits  These costs relate to

employment-related costs paid by an
employer such as insurance programs,
retirement plans, and supplemental
unemployment programs. They also include
the employer’s share of Social Security,
Medicare, workers’ compensation, federal
employment tax, and state unemployment
64 insurance.

1. These costs often add up to 30% to 40% of

an employee’s base pay.
2. Some companies include all of these costs in
manufacturing overhead. Other companies
opt for the conceptually superior method of
treating fringe benefit expenses of direct
laborers as additional direct labor costs.

VIII. Appendix 2B: cost of quality (Slide #65 is the title slide)

Learning Objective 9: Identify the four types of quality

66 costs and explain how they interact.
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A.

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Quality costs  Costs incurred to prevent defects or that result from defects in products.
Many companies are working hard to reduce their quality costs. Those companies that
are succeeding have a high quality of conformance in the sense that the overwhelming
majority of the products that they produce conform to design specifications and are free
from defects.
67
B. There are four broad categories of quality costs:

i. Prevention costs  Are incurred to support

activities whose purpose is to reduce the
number of defects.

Helpful Hint: Suppose an ice cream company has been

having problems with unpleasant gritty ice crystals in
its ice cream. Ask students how they would prevent the
ice crystal defect. One approach would be to
68 investigate the manufacturing process. Perhaps the
gritty ice crystals are caused by temperature variations
in the freezer. Controlled experiments could be run
varying the temperature and inspecting for ice crystals.
If this is the cause, the variation in temperature could
be decreased or the ingredients changed so they would
be less sensitive to temperature changes.

ii. Appraisal costs  Are incurred to identify

defective products before the products are
shipped to customers.

Helpful Hint: Continuing the ice cream example, ask

students how they would “inspect out” the ice crystal
problem. This may be more difficult and expensive than
it first appears. For example, the problem could occur
only in half-gallon containers or at random in a small
(but important) number of containers. Or, the ice
crystals could only be detected by tasting ice cream

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 near the bottom of the container. “Inspecting out” the
problem would make a lot of ice cream unsaleable.

iii. Internal failure costs  Are incurred as a

result of identifying defects before they are
shipped to customers.
69
iv. External failure costs  Are incurred as a
result of defective products being delivered to
customers.

Helpful Hint: Continuing with the ice cream example,

ask students to identify examples of internal and
external failure costs. Internal failure costs could result
from throwing away defective ice cream. External
failure costs could result from customers returning
defective ice cream or failing to purchase the ice cream
company’s product at a later date.

v. Examples of each type of quality cost include:

1. Prevention  Quality training, quality

circles, statistical process control activities,
etc.
2. Appraisal  Testing and inspection of
incoming materials, final product testing,
70
depreciation of testing equipment, etc.
3. Internal failure  Scrap, spoilage, rework,
etc.
4. External failure  Cost of field servicing
and handling customer complaints, warranty
repairs, lost sales arising from reputation of
70 poor quality, etc.

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 vi. Distribution of quality costs  Graphs are
often used to depict the relationship between
the four types of quality costs. The graph
illustrates four key concepts.

1. When the quality of conformance is low,

total quality cost is high and most of this
cost consists of internal and external failure
costs.
2. Total quality costs drop rapidly as the
quality of conformance increases.
3. Companies reduce their total quality costs
by focusing their efforts on prevention and
appraisal because the cost savings from
reduced defects usually overwhelm the costs
71 of additional prevention and appraisal.

Helpful Hint: Continuing with the ice cream example,

the prevention activities mentioned earlier may reveal
that, if fluctuating temperatures is the problem, a
simple thermostat may solve the problem. The cost to
identify the problem and install a thermostat is much
less that the costs of scrapped ice cream, customer
returns and complaints, and lost future business.

4. Total quality costs are minimized when the

quality of conformance is less than 100%.
This is a debatable point in the sense that
some experts believe that total quality costs
are not minimized until the quality of
conformance is 100%.

Learning Objective 10: Prepare and interpret a quality

72 cost report.

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 C. Quality cost report  This report details the
prevention, appraisal, internal failure, and external
failure costs that arise from a company’s current quality
control efforts.

i. When interpreting a cost of quality report

73 managers should look for two trends. First,
increases in prevention and appraisal costs
should be more than offset by decreases in
internal and external failure costs. Second, the
total quality costs as a percent of sales should
decrease.

ii. Quality cost reports can also be prepared in

graphic form. Managers should still look for
74 the same two trends whether the data are
presented in a graphic or table format.

iii. Uses of quality cost information:

1. It helps managers see the financial

significance of defects.
2. It helps managers identify the relative
importance of the quality problems faced by
75 the company.
3. It helps managers see whether their quality
costs are poorly distributed. In general, costs
should be distributed more toward
prevention and to a lesser extent appraisal
than toward failures.

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 iv. Limitations of quality cost information

1. Simply measuring and reporting quality cost

problems does not solve quality problems.
2. Results usually lag behind quality
improvement programs. Initially,
76 prevention and appraisal cost increases may
not be offset by decreases in failure costs.
3. The most important quality cost, lost sales
arising from customer ill-will, is often
omitted from quality cost reports because it
is difficult to estimate.
IX. International aspects of quality
A. The International Organization for Standardization,
based in Geneva Switzerland, has established quality
control guidelines, known as the ISO 9000 standards.
For a company to become ISO 9000 certified by a
certifying agency, it must demonstrate that:

i. A quality control system is in use, and the

system clearly defines an expected level of
quality.
77 ii. The system is fully operational and is backed
up with detailed documentation of quality
control procedures.
iii. The intended level of quality is being
achieved on a sustained basis.
B. Although the ISO 9000 standards were developed in
Europe they have become widely accepted elsewhere
throughout the world, including the United States and
Asia.

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