Chapter 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

Examples

2-1 Computing and interpreting manufacturing unit costs.

Minnesota Office Products (MOP) produces three different paper products at its Vaasa lumber
plant: Supreme, Deluxe, and Regular. Each product has its own dedicated production line at the
plant. It currently uses the following three-part classification for its manufacturing costs: direct
materials, direct manufacturing labor, and manufacturing overhead costs. Total manufacturing
overhead costs of the plant in July 2014 are $150 million ($15 million of which are fixed). This
total amount is allocated to each product line on the basis of the direct manufacturing labor
costs of each line. Summary data (in millions) for July 2014 are as follows:

Supreme Deluxe Regular

Direct material costs $ 89 $ 57 $ 60
Direct manufacturing labor costs $ 16 $ 26 $ 8
Manufacturing overhead costs $ 48 $ 78 $ 24
Units produced 125 150 140

Required:
1. Compute the manufacturing cost per unit for each product produced in July 2014.
2. Suppose that, in August 2014, production was 150 million units of Supreme, 190 million units
of Deluxe, and 220 million units of Regular. Why might the July 2014 information on
manufacturing cost per unit be misleading when predicting total manufacturing costs in
August 2014?

SOLUTION

1.
(in millions)
Supreme Deluxe Regular Total
Direct material cost $ 89.00 $ 57.00 $60.00 $206.00
Direct manuf. labor costs 16.00 26.00 8.00 50.00
Manufacturing overhead costs 48.00 78.00 24.00 150.00
Total manuf. costs 153.00 161.00 92.00 406.00
Fixed costs allocated at a rate
of $15M  $50M (direct mfg.
labor) equal to $0.30 per
dir. manuf. labor dollar
(0.30  $16; 26; 8) 4.80 7.80 2.40 15.00
Variable costs $148.20 $153.20 $89.60 $391.00
Units produced (millions) 125 150 140
Cost per unit (Total manuf.
costs ÷ units produced) $1.2240 $1.0733 $0.6571
Variable manuf. cost per unit
(Variable manuf. costs
 Units produced) $1.1856 $1.0213 $0.6400

(in millions)

1
 Supreme Deluxe Regular Total
2. Based on total manuf. cost
per unit ($1.2240  150;
$1.0733  190; $0.6571  220) $183.60 $203.93 $144.56 $532.09
Correct total manuf. costs based
on variable manuf. costs plus
fixed costs equal
Variable costs ($1.1856  150; $177.84 $194.05 $140.80 $512.69
$1.0213  190; $0.64  220)
Fixed costs 15.00
Total costs $527.69

The total manufacturing cost per unit in requirement 1 includes $15 million of indirect
manufacturing costs that are fixed irrespective of changes in the volume of output per month,
while the remaining variable indirect manufacturing costs change with the production volume.
Given the unit volume changes for August 2014, the use of total manufacturing cost per unit
from the past month at a different unit volume level (both in aggregate and at the individual
product level) will overestimate total costs of $532.09 million in August 2014 relative to the
correct total manufacturing costs of $527.69 million calculated using variable manufacturing cost
per unit times units produced plus the fixed costs of $15 million.

2
2-2 Classification of costs, merchandising sector.

Band Box Entertainment (BBE) operates a large store in Atlanta, Georgia. The store has both a
movie (DVD) section and a music (CD) section. BBE reports revenues for the movie section
separately from the music section.

Required: Classify each cost item (A–H) as follows:

a. Direct or indirect (D or I) costs of the total number of DVDs sold.

b. Variable or fixed (V or F) costs of how the total costs of the movie section change as the total
number of DVDs sold changes. (If in doubt, select on the basis of whether the total costs will
change substantially if there is a large change in the total number of DVDs sold.)
You will have two answers (D or I; V or F) for each of the following items:

Cost Item D or I V or F
A. Annual retainer paid to a video distributor
B. Cost of store manager’s salary
C. Costs of DVDs purchased for sale to customers
D. Subscription to DVD Trends magazine
E. Leasing of computer software used for financial budgeting at the BBE store
F. Cost of popcorn provided free to all customers of the BBE store
G. Cost of cleaning the store every night after closing
H. Freight-in costs of DVDs purchased by BBE

SOLUTION

Cost object: DVDs sold in movie section of store

Cost variability: With respect to changes in the number of DVDs sold
There may be some debate over classifications of individual items, especially with regard
to cost variability.

Cost Item D or I V or F
A D F
B I F
C D V
D D F
E I F
F I V
G I F
H D V

3
2-3 Variable costs, fixed costs, total costs.

Bridget Ashton is getting ready to open a small restaurant. She is on a tight budget and must
choose between the following long-distance phone plans:

Plan A: Pay 10 cents per minute of long-distance calling.

Plan B: Pay a fixed monthly fee of $15 for up to 240 long-distance minutes and 8 cents per
minute thereafter (if she uses fewer than 240 minutes in any month, she still pays $15 for
the month).
Plan C: Pay a fixed monthly fee of $22 for up to 510 long-distance minutes and 5 cents per
minute there- after (if she uses fewer than 510 minutes, she still pays $22 for the month).
Required:
1. Draw a graph of the total monthly costs of the three plans for different levels of monthly
long-distance calling.
2. Which plan should Ashton choose if she expects to make 100 minutes of long-distance calls?
240 minutes? 540 minutes?

SOLUTION
1.
Minutes/month 0 50 100 150 200 240 300 327.5 350 400 450 510 540 600 650
Plan A ($/month) 0 5 10 15 20 24 30 32.75 35 40 45 51 54 60 65
Plan B ($/month) 15 15 15 15 15 15 19.80 22 23.80 27.80 31.80 36.60 39 43.80 47.80
Plan C ($/month) 22 22 22 22 22 22 22 22 22 22 22 22 23.50 26.50 29

2. In each region, Ashton chooses the plan that has the lowest cost. From the graph (or from
calculations)*, we can see that if Ashton expects to use 0–150 minutes of long-distance each
month, she should buy Plan A; for 150–327.5 minutes, Plan B; and for more than 327.5 minutes,
Plan C. If Ashton plans to make 100 minutes of long-distance calls each month, she should
choose Plan A; for 240 minutes, choose Plan B; for 540 minutes, choose Plan C.
*Let x be the number of minutes when Plan A and Plan B have equal cost
$0.10x = $15
x = $15 ÷ $0.10 per minute = 150 minutes.
Let y be the number of minutes when Plan B and Plan C have equal cost
$15 + $0.08 (y – 240) = $22
$0.08 (y – 240) = $22 – $15 = $7
$7
y – 240 =  87.5
$0.08
y = 87.5 + 240 = 327.5 minutes

4
2-4 Total costs and unit costs

The Big Event (TBE) recently started a business organizing food and music at weddings and
other large events. In order to better understand the profitability of the business, the owner has
asked you for an analysis of costs—what costs are fixed, what costs are variable, and so on, for
each event. You have the following cost information:

Music costs: $10,000 per event

Catering costs:
Food: $65 per guest
Setup/cleanup: $15 per guest
Fixed fee: $4,000 per event

The Big Event has allowed the caterer, who is also new in business, to place business cards on
each table as a form of advertising. This has proved quite effective, and the caterer gives TBE a
discount of $5 per guest in exchange for allowing the caterer to advertise.

Required:
1. Draw a graph depicting fixed costs, variable costs, and total costs for each event versus the
number of guests.
2. Suppose 150 persons attend the next event. What is TBE’s total net cost and the cost per
attendee?
3. Suppose instead that 200 persons attend. What is TBE’s total net cost and the cost per
attendee.
4. How should TBE charge customers for its services? Explain briefly.

SOLUTION

1.
Number of guests 0 50 100 150 200 250 300
Variable cost per guest
($80 caterer charge –
$5 discount for advertising) $75 $75 $75 $75 $75 $75 $75
Fixed Costs $14,000 $14,000 $14,000 $14,000 $14,000 $14,000 $14,000
Variable costs (number of
guests × variable cost per
guest) 0 3,750 7,500 11,250 15,000 18,750 22,500
Total costs (fixed + variable) $14,000 $17,750 $21,500 $25,250 $29,000 $32,750 $36,500

5
2.
Number of guests 0 50 100 150 200 250 300
Total costs
(fixed + variable) $14,000 $17,750 $21,500 $25,250 $29,000 $32,750 $36,500
Costs per guest (total costs  $168.3
number of guests) $355 $215 3 $ 145 $131 $121.67

As shown in the table above, for 150 attendees the total cost will be $25,250, and the cost per
attendee will be $168.33.

3. As shown in the table in requirement 2, for 200 attendees, the total cost will be $29,000, and
the cost per attendee will be $145.

4. TBE should charge customers based on the number of guests. As the number of guests
increase, TBE could offer price discounts because its fixed costs would be spread over a
larger number of guests.

Alternatively, TBE could charge a flat fee of $10,000 plus a margin for the music. The
catering costs would then vary less with the number of guests because only $4,000 of fixed costs
would be spread over the number of guests. For 100 guests, the fixed catering cost per guest
would be $40 ($4,000 ÷ 100 guests); for 200 guests, it would be $20 ($4,000 ÷ 200 guests).
TBE’s total cost would be $115 (variable cost per guest of $75 + fixed catering cost per guest of
$40) for 100 guests and $95 (variable cost per guest of $75 + fixed catering cost per guest of
$20) for 200 guests.

6
2-5 Computing cost of goods purchased and cost of goods sold.

The following data are for Marvin Department Store. The account balances (in thousands) are
for 2014.

Marketing, distribution, and customer-service costs $ 37,000

Merchandise inventory, January 1, 2014 27,000
Utilities 17,000
General and administrative costs 43,000
Merchandise inventory, December 31, 2014 34,000
Purchases 155,000
Miscellaneous costs 4,000
Transportation-in 7,000
Purchase returns and allowances 4,000
Purchase discounts 6,000
Revenues 280,000

Required:
1. Compute (a) the cost of goods purchased and (b) the cost of goods sold.
2. Prepare the income statement for 2014.

SOLUTION
1a.
Marvin Department Store
Schedule of Cost of Goods Purchased
For the Year Ended December 31, 2014
(in thousands)

Purchases $155,000
Add transportation-in 7,000
162,000
Deduct:
Purchase returns and allowances $4,000
Purchase discounts 6,000 10,000

Cost of goods purchased $152,000

1b. Marvin Department Store

Schedule of Cost of Goods Sold
For the Year Ended December 31, 2014
(in thousands)

Beginning merchandise inventory 1/1/2014 $ 27,000

Cost of goods purchased (see above) 152,000
Cost of goods available for sale 179,000
Ending merchandise inventory 12/31/2014 34,000
Cost of goods sold $145,000

7
2. Marvin Department Store
Income Statement
Year Ended December 31, 2014
(in thousands)

Revenues $280,000
Cost of goods sold (see above) 145,000
Gross margin 135,000
Operating costs
Marketing, distribution, and customer
service costs $37,000
Utilities 17,000
General and administrative costs 43,000
Miscellaneous costs 4,000
Total operating costs 101,000
Operating income $ 34,000

8
2-6 Inventoriable costs versus period costs.

Each of the following cost items pertains to one of these companies: Star Market (a
merchandising-sector company), Maytag (a manufacturing-sector company), and Yahoo! (a
service-sector company):

a. Cost of lettuce and tomatoes on sale in Star Market’s produce department

b. Electricity used to provide lighting for assembly-line workers at a Maytag refrigerator-
assembly plant
c. Depreciation on Yahoo!’s computer equipment used to update its Website
d. Electricity used to provide lighting for Star Market’s store aisles
e. Depreciation on Maytag’s computer equipment used for quality testing of refrigerator
components during the assembly process
f. Salaries of Star Market’s marketing personnel planning local-newspaper advertising
campaigns
g. Perrier mineral water purchased by Yahoo! for consumption by its software engineers
h. Salaries of Yahoo!’s marketing personnel selling advertising
i. Depreciation on vehicles used to transport Maytag refrigerators to retail stores

Required:
1. Distinguish between manufacturing-, merchandising-, and service-sector companies.
2. Distinguish between inventoriable costs and period costs.
3. Classify each of the cost items (a–h) as an inventoriable cost or a period cost. Explain your
answers.

SOLUTION

1. Manufacturing-sector companies purchase materials and components and convert them

into different finished goods.
Merchandising-sector companies purchase and then sell tangible products without
changing their basic form.
Service-sector companies provide services or intangible products to their customers—for
example, legal advice or audits.
Only manufacturing and merchandising companies have inventories of goods for sale.

2. Inventoriable costs are all costs of a product that are regarded as an asset when they are
incurred and then become cost of goods sold when the product is sold. These costs for a
manufacturing company are included in work-in-process and finished goods inventory (they are
“inventoried”) to build up the costs of creating these assets.
Period costs are all costs in the income statement other than cost of goods sold. These
costs are treated as expenses of the period in which they are incurred because they are presumed
not to benefit future periods (or because there is not sufficient evidence to conclude that such
benefit exists). Expensing these costs immediately best matches expenses to revenues.

3. (a) Lettuce and tomatoes purchased for resale by Star market—inventoriable cost of a
merchandising company. It becomes part of cost of goods sold when the lettuce and tomatoes are
sold.

9
 (b) Electricity used for lighting at Maytag refrigerator assembly plant—inventoriable cost
of a manufacturing company. It is part of the manufacturing overhead that is included in the
manufacturing cost of a refrigerator finished good.
(c) Depreciation on Yahoo!’s computer equipment used to update directories of websites
—period cost of a service company. Yahoo! has no inventory of goods for sale and, hence, no
inventoriable cost.
(d) Electricity used to provide lighting for Star Market’s store aisles—period cost of a
merchandising company. It is a cost that benefits the current period, and it is not traceable to
goods purchased for resale.
(e) Depreciation on Maytag’s assembly testing equipment—inventoriable cost of a
manufacturing company. It is part of the manufacturing overhead that is included in the
manufacturing cost of a refrigerator finished good.
(f) Salaries of Star Market’s marketing personnel—period cost of a merchandising
company. It is a cost that is not traceable to goods purchased for resale. It is presumed not to
benefit future periods (or at least not to have sufficiently reliable evidence to estimate such future
benefits).
(g) Perrier mineral water consumed by Yahoo!’s software engineers—period cost of a
service company. Yahoo! has no inventory of goods for sale and, hence, no inventoriable cost.
(h) Salaries of Yahoo!’s marketing personnel—period cost of a service company. Yahoo!
has no inventory of goods for sale and, hence, no inventoriable cost.

10