11 Edition: Mcgraw Hill/Irwin

11th Edition
Chapter 2
McGrawHill/Irwin Copyright © 2006, The McGrawHill Companies, Inc.
Costs Terms, Concepts and
Classifications
Chapter Two
Manufacturing Costs
Direct Direct Manufacturing

Materials Labor Overhead
The Product
Direct Materials
Raw materials that become an integral part of the

product and that can be conveniently traced
directly to it.
Example: A radio installed in an automobile
Direct Labor
Those labor costs that can be easily traced to

individual units of product.
Example: Wages paid to automobile assembly workers
Manufacturing Overhead
Manufacturing costs that cannot be traced directly

to specific units produced.
Examples: Indirect labor and indirect materials
Wages paid to employees Materials used to support

who are not directly the production process.
involved in production
work. Examples: lubricants and
Examples: maintenance cleaning supplies used in the
workers, janitors and automobile assembly plant.
security guards.
Classifications of Costs
Manufacturing costs are often

classified as follows:
Direct Direct Manufacturing

Material Labor Overhead
Prime Conversion
Cost Cost
Non-manufacturing Costs
Marketing or Administrative
Selling Cost Cost
Costs necessary to get All executive,

the order and deliver organizational, and
the product. clerical costs.
Product Costs Versus Period Costs
Product costs include Period costs include all

direct materials, direct marketing or selling
labor, and manufacturing costs and
overhead.
administrative costs.
Inventory Cost of Good Sold Expense
Sale
Balance Income Income

Sheet Statement Statement
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.
D. Electrical costs to light the production
facility.
E. Sales commissions.
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.
D. Electrical costs to light the production
facility.
E. Sales commissions.
Comparing Merchandising and
Manufacturing Activities
Merchandisers . . . Manufacturers . . .
 Buy finished goods.  Buy raw materials.
 Sell finished goods.  Produce and sell
finished goods.
MegaLoMart
Balance Sheet
Merchandiser Manufacturer
Current assets Current Assets
Cash ◆ Cash
Receivables ◆ Receivables
Prepaid Expenses ◆ Prepaid Expenses

◆ Inventories
Merchandise
Inventory Raw Materials
Work in Process
Finished Goods
Balance Sheet
Merchandiser Manufacturer
Current assets Current Assets
Cash ◆ Cash
Receivables ◆ Receivables
Materials waiting to
Prepaid Expenses be processed.
◆ Prepaid Expenses
Partially complete ◆ Inventories
Merchandise
products – some
Inventory Raw Materials
material, labor, or Work in Process
overhead has been Finished Goods
added.
Completed products
awaiting sale.
The Income Statement
Cost of goods sold for manufacturers differs only

slightly from cost of goods sold for merchandisers.
Merchandising Company
Cost of goods sold:
Beg. merchandise
inventory $ 14,200
+ Purchases 234,150
Goods available
for sale $ 248,350
- Ending
merchandise
inventory (12,100)
= Cost of goods
sold $ 236,250
Inventory Flows
Beginning
Additions Available
balance + $$$ = $$$$$
$$
Available _ Withdrawals Ending

$$$$$ $$$ = balance
$$
Quick Check 
If your inventory balance at the beginning of the

month was $1,000, you bought $100 during the
month, and sold $300 during the month, what would
be the balance at the end of the month?
A. $1,000.
B. $ 800.
C. $1,200.
D. $ 200.
Quick Check 
If your inventory balance at the beginning of the

month was $1,000, you bought $100 during the
month, and sold $300 during the month, what would
be the balance at the end of the month?
A. $1,000.
$1,000 + $100 = $1,100
B. $ 800. $1,100 - $300 = $800
C. $1,200.
D. $ 200.
Schedule of Cost of Goods
Manufactured
Calculates the cost of raw

material, direct labor and
manufacturing overhead used
in production.
Calculates the manufacturing

costs associated with goods
that were finished during the
period.
Product Cost Flows
Manufacturing Work
Raw Materials Costs In Process
Beginning raw Direct materials

materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production
– Ending raw materials
inventory
= Raw materials used As items are removed from raw
in production materials inventory and placed into
the production process, they are
called direct materials.
Product Cost Flows
Manufacturing Work
Conversion
Beginning raw Direct materials
materials inventory + Direct labor
costs are costs
+ Raw materials + Mfg. overhead incurred to
purchased = Total manufacturing convert the
= Raw materials costs
direct material
available for use
in production into a finished
– Ending raw materials product.
inventory
= Raw materials used
in production
Product Cost Flows
Manufacturing Work
Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials
inventory All manufacturing costs incurred
= Raw materials used during the period are added to the
in production
beginning balance of work in
process.
Product Cost Flows
Manufacturing Work
Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending work in
process inventory
Costs associated with the goods that
= Cost of goods
are completed during the period are manufactured
transferred to finished goods
inventory.
Product Cost Flows
Manufacturing Cost Flows
Balance Sheet Income

Costs Inventories Statement
Expenses
Material Purchases Raw Materials
Direct Labor Work in

Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold
Selling and Period Costs Selling and

Administrative Administrative
Quick Check 
Beginning raw materials inventory was $32,000.

During the month, $276,000 of raw material was
purchased. A count at the end of the month
revealed that $28,000 of raw material was still
present. What is the cost of direct material used?
A. $276,000
B. $272,000
C. $280,000
D. $ 2,000
Quick Check 
Beginning raw materials inventory was $32,000.

During the month, $276,000 of raw material was
purchased. A count at the end of the month
revealed that $28,000 of raw material was still
present. What is the cost of direct material used?
A. $276,000
B. $272,000
C. $280,000
D. $ 2,000
Quick Check 
Direct materials used in production totaled

$280,000. Direct labor was $375,000 and
factory overhead was $180,000. What were
total manufacturing costs incurred for the
month?
A. $555,000
B. $835,000
C. $655,000
D. Cannot be determined.
Quick Check 
Direct materials used in production totaled

$280,000. Direct labor was $375,000 and
factory overhead was $180,000. What were
total manufacturing costs incurred for the
month?
A. $555,000
B. $835,000
C. $655,000
Quick Check 
Beginning work in process was $125,000.

Manufacturing costs incurred for the month
were $835,000. There were $200,000 of
partially finished goods remaining in work
in process inventory at the end of the
month. What was the cost of goods
manufactured during the month?
A. $1,160,000
B. $ 910,000
C. $ 760,000
Quick Check 
Beginning work in process was $125,000.

Manufacturing costs incurred for the month
were $835,000. There were $200,000 of
partially finished goods remaining in work
in process inventory at the end of the
month. What was the cost of goods
manufactured during the month?
A. $1,160,000
B. $ 910,000
C. $ 760,000
Quick Check 
Beginning finished goods inventory was

$130,000. The cost of goods manufactured
for the month was $760,000. And the ending
finished goods inventory was $150,000.
What was the cost of goods sold for the
month?
A. $ 20,000.
B. $740,000.
C. $780,000.
D. $760,000.
Quick Check 
Beginning finished goods inventory was

$130,000. The cost of goods manufactured
for the month was $760,000. And the ending
finished goods inventory was $150,000.
What was the cost of goods sold for the
month?
A. $ 20,000. $130,000 + $760,000 = $890,000
B. $740,000. $890,000 - $150,000 = $740,000
C. $780,000.
D. $760,000.
Cost Classifications for Predicting Cost
Behavior
How a cost will react to

changes in the level of
activity within the
relevant range.
 Total variable costs
change when activity
changes.
 Total fixed costs remain
unchanged when activity
changes.
Total Variable Cost
Your total long distance telephone bill is based

on how many minutes you talk.
Total Long Distance
Telephone Bill
Minutes Talked
Variable Cost Per Unit
The cost per long distance minute talked is

constant. For example, 10 cents per minute.
Telephone Charge
Per Minute
Minutes Talked
Total Fixed Cost
Your monthly basic telephone bill probably

does not change when you make more local
calls.
Telephone Bill
Monthly Basic
Number of Local Calls

Fixed Cost Per Unit
The average fixed cost per local call decreases

as more local calls are made.
Monthly Basic Telephone

Bill per Local Call
Number of Local Calls
Cost Classifications for Predicting Cost
Behavior
Behavior of Cost (within the relevant range)

Cost In Total Per Unit
Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Average fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.
Quick Check 
Which of the following costs would be variable with

respect to the number of cones sold at a Baskins &
Robbins shop? (There may be more than one
correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
Quick Check 
Which of the following costs would be variable with

respect to the number of cones sold at a Baskins &
Robbins shop? (There may be more than one
correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
Assigning Costs to Cost Objects
Direct costs Indirect costs

• Costs that can be • Costs that cannot be easily
easily and conveniently and conveniently traced to
traced to a unit of product a unit of product or other
or other cost object. cost object.
• Examples: direct material • Example: manufacturing
and direct labor overhead
Cost Classifications for Decision
Making
• Every decision involves a choice between at

least two alternatives.
• Only those costs and benefits that differ

between alternatives are relevant in a decision.
All other costs and benefits can and should be
ignored.
Differential Costs and Revenues
Costs and revenues that differ among

alternatives.
Example: You have a job paying $1,500 per month in

your hometown. You have a job offer in a neighboring
city that pays $2,000 per month. The commuting cost
to the city is $300 per month.
Differential revenue is:

$2,000 – $1,500 = $500
Differential cost is:

$300
Opportunity Costs
The potential benefit that is given

up when one alternative is
selected over another.
Example: If you were

not attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college for
one year is $15,000.
Sunk Costs
Sunk costs have already been incurred and cannot be

changed now or in the future. They should be
ignored when making decisions.
Example: You bought an automobile that cost

$10,000 two years ago. The $10,000 cost is sunk
because whether you drive it, park it, trade it, or sell
it, you cannot change the $10,000 cost.
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?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.
Quick Check 

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?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.
Quick Check 

waste money needlessly. Is the annual cost of
licensing your car relevant in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
Quick Check 

waste money needlessly. Is the annual cost of
licensing your car relevant in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
Quick Check 
Suppose that your car could be sold now for

$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.
Quick Check 
Suppose that your car could be sold now for

$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.
Summary of the Types of Cost
Classifications
• Financial reporting
• Predicting cost behavior
• Assigning costs to cost objects
• Decision making
Idle Time
Machine Material
Breakdowns Shortages
Power
Failures
The labor costs incurred

during idle time are ordinarily
treated as manufacturing
overhead.
Overtime
The overtime premiums for all factory

workers are usually considered to be part
of manufacturing overhead.
Labor Fringe Benefits
Fringe benefits include employer paid

costs for insurance programs, retirement
plans, supplemental unemployment
programs, Social Security, Medicare,
workers’ compensation and
unemployment taxes.
Some companies Other companies treat

include all of these fringe benefit
costs in expenses of direct
manufacturing laborers as additional
overhead. direct labor costs.
Quality of Conformance
When the overwhelming majority of

products produced conform to design
specifications and are free from
defects.
Prevention and Appraisal Costs
Support activities
Prevention whose purpose is to
Costs reduce the number of
defects
Incurred to identify
defective products
Appraisal Costs before the products are
shipped
Internal and External Failure Costs
Incurred as a result of
Internal Failure
identifying defects
Costs before they are shipped
Incurred as a result of
External Failure defective products
Costs being delivered to
customers
Examples of Quality Costs
Appraisal Costs
Prevention Costs • Testing & inspecting
• Quality training
incoming materials
• Quality circles
• Final product testing
• Statistical process
• Depreciation of testing
control activities
equipment
External Failure Costs

Internal Failure Costs • Cost of field servicing &
• Scrap
handling complaints
• Spoilage
• Warranty repairs
• Rework
• Lost sales
Distribution of Quality Costs
When quality of conformance is low,

total quality cost is high and consists
mostly of internal and external failure.
Companies can reduce

their total quality cost by
focusing on prevention and
appraisal. The cost savings
from reduced defects
usually swamps the costs
of the additional prevention
and appraisal efforts.
Ventura Company
Quality Cost Report
For Years 1 and 2
Year 2 Year 1
Amount Percent* Amount Percent*
Prevention costs:
Systems development $ 400,000 0.80% $ 270,000 0.54%
Quality training 210,000 0.42% 130,000 0.26%
Supervision of prevention activities 70,000 0.14% 40,000 0.08%
Quality improvement 320,000 0.64% 210,000 0.42%
Total prevention cost 1,000,000 2.00% 650,000 1.30%
Appraisal costs: Quality cost

Inspection
Reliability testing
600,000
580,000
1.20%
1.16%
560,000
420,000
1.12%
0.84%
reports provide
Supervision of testing and inspection
Depreciation of test equipment
120,000
200,000
0.24%
0.40%
80,000
140,000
0.16%
0.28%
an estimate of
Total appraisal cost 1,500,000 3.00% 1,200,000 2.40%
the financial
Internal failure costs:
Net cost of scrap 900,000 1.80% 750,000 1.50%
consequences
Rework labor and overhead 1,430,000 2.86% 810,000 1.62% of the
Downtime due to defects in quality 170,000 0.34% 100,000 0.20%
Disposal of defective products 500,000 1.00% 340,000 0.68% company’s
Total internal failure cost 3,000,000 6.00% 2,000,000 4.00%
current defect
External failure costs:
Warranty repairs 400,000 0.80% 900,000 1.80% rate.
Warranty replacements 870,000 1.74% 2,300,000 4.60%
Allowances 130,000 0.26% 630,000 1.26%
Cost of field servicing 600,000 1.20% 1,320,000 2.64%
Total external failure cost 2,000,000 4.00% 5,150,000 10.30%
Total quality cost $ 7,500,000 15.00% $ 9,000,000 18.00%
* AsMcGrawHill/Irwin
a percentage of total sales. In each year sales totaled $50,000,000. Copyright © 2006, The McGrawHill Companies, Inc.
Quality Cost Reports: Graphic Form
$10 20
9
Quality 18
Quality Cost as a Percentage of Sales

8
reports 16
Quality Cost (in millions)
7
External External
can also 14
External External
6 Failure Failure
be 12 Failure Failure
5
prepared 10
4 Internal
Failure
in 8 Internal
Failure
3 Internal
Failure
graphic 6 Internal
Failure
2
Appraisal form. 4
Appraisal
Appraisal Appraisal
1 2
Prevention Prevention Prevention Prevention
0 0
1 2 1 2
Year Year
Uses of Quality Cost Information
Help managers see the

financial significance of
defects.
Help managers identify

the relative importance of
the quality problems.
Help managers see

whether their quality
costs are poorly
McGrawHill/Irwin
distributed. Copyright © 2006, The McGrawHill Companies, Inc.
Limitations of Quality Cost Information
Simply measuring quality

cost problems does not
solve quality problems.
Results usually lag

behind quality
improvement programs.
The most important

quality cost, lost sales, is
often omitted from
quality cost reports.
ISO 9000 Standards
ISO 9000 standards have become an

international measure of quality. To become
ISO 9000 certified, a company must
demonstrate:
1. A quality control system is in use, and the

system clearly defines an expected level of
quality.
2. The system is fully operational and is
backed up with detailed documentation of
quality control procedures.
3. The intended level of quality is being
achieved on a sustained basis.
End of Chapter 2

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11th Edition

Direct Direct Manufacturing

Raw materials that become an integral part of the

Example: A radio installed in an automobile

Those labor costs that can be easily traced to

Example: Wages paid to automobile assembly workers

Manufacturing costs that cannot be traced directly

Examples: Indirect labor and indirect materials

Wages paid to employees Materials used to support

Manufacturing costs are often

Direct Direct Manufacturing

Costs necessary to get All executive,

Product costs include Period costs include all

Inventory Cost of Good Sold Expense

Balance Income Income

Which of the following costs would be considered a

Which of the following costs would be considered a

Prepaid Expenses ◆ Prepaid Expenses

Cost of goods sold for manufacturers differs only

Available _ Withdrawals Ending

If your inventory balance at the beginning of the

If your inventory balance at the beginning of the

Calculates the cost of raw

Calculates the manufacturing

Beginning raw Direct materials

Beginning raw Direct materials Beginning work in

Beginning raw Direct materials Beginning work in

Balance Sheet Income

Direct Labor Work in

Selling and Period Costs Selling and

Beginning raw materials inventory was $32,000.

Beginning raw materials inventory was $32,000.

Direct materials used in production totaled

Direct materials used in production totaled

Beginning work in process was $125,000.

Beginning work in process was $125,000.

Beginning finished goods inventory was

Beginning finished goods inventory was

How a cost will react to

Your total long distance telephone bill is based

The cost per long distance minute talked is

Your monthly basic telephone bill probably

Number of Local Calls

The average fixed cost per local call decreases

Monthly Basic Telephone

Behavior of Cost (within the relevant range)

Which of the following costs would be variable with

Which of the following costs would be variable with

Direct costs Indirect costs

• Every decision involves a choice between at

• Only those costs and benefits that differ

Costs and revenues that differ among

Example: You have a job paying $1,500 per month in

Differential revenue is:

Differential cost is:

The potential benefit that is given

Example: If you were

Sunk costs have already been incurred and cannot be

Example: You bought an automobile that cost