02: Various Cost Terms

Minjae Koo
 Table of Contents

• Where do Managers Assign Costs?

• Direct vs Indirect Costs
• Variable vs Fixed Costs
• Cost Drivers and Relevant Range
• Inventoriable vs Period Costs
• Are Product Costs and Inventoriable Costs the Same?
• Various Combination of Cost Terms
• How do Managers Record Costs in Financial Statement?
• Other Cost Terms
Where Do Managers Assign Costs?
■ Review of Cost and Introduction to Cost Object
□ Cost: Total resources managers use.
□ Follow-up Questions:
o Why are costs important to managers?
– Every $ reduction in cost results in $ increase in operating income.
o What do managers do with costs?
– First, they collect cost in a systematic way (Cost Accumulation).
– Second, they identify and assign costs (Cost Assignment).
o Where do they assign cost?
– To cost objects.
o Are costs perfectly assigned?
– Not always.
Where Do Managers Assign Costs?
■ Review of Cost and Introduction to Cost Object (cont.)
□ Cost Object: Anything you need to determine the cost of.
o Examples:
– Cost of buying a new iPhone
– Cost of launching a new product
– Cost of this class

Unnecessary meetings can cost big companies $100 million a year

Large companies could save as much as $100 million a year by holding fewer unnecessary meetings and cutting
down on their invite lists, according to a recent study.
Overall, companies spend a total of $37 billion per year on meetings, according to Harvard Business Review,
underlining the enormous investment in such communications. For example, a previous study by Rogelberg
published in Small Group Research, a scholarly journal, cited research that found copy-machine maker Xerox spent
more than $100 million a year on meetings in their manufacturing and development unit.
According to research in the MIT Sloan Management Review, some 70% of corporate managers reported that
meetings were costly and unproductive. (CBS News, 2022/09/30) Meeting can be a cost object!
Direct vs Indirect Costs
■ Direct Costs (a.k.a. Traceable Costs): Costs that can be directly and
easily traced to a cost object.
o Example 1: Suppose you run a bakery and you want to determine
cost associated with making a batch of cupcakes. What are direct
costs?

– Ingredients: Flour, egg, sugar, butter, etc.

– Packaging: Cupcake liners, boxes, etc.
– Labor: The wages of the bakers.
Direct vs Indirect Costs
■ Direct Costs (cont.)
o Example 2: Let’s turn our focus to real business settings. What are direct
costs associated with Google Pixel smartphones?

– Materials: Processors, displays, cameras, batteries, etc.

– Labor Costs: The wages assembly line workers.
– Packaging: Boxes, manuals, and accessories.
Direct vs Indirect Costs
■ Indirect Costs: Costs that are related but not directly or easily traced
to a cost object.
o Example 1: Let’s revisit cupcake case. What are indirect costs?

– Rent expenses.
– Utilities: The cost of electricity, water, and gas.
– Salaries and wages: The salaries of administrative staff
– Depreciation
– Cleaning and maintenance
– Marketing
Direct vs Indirect Costs
■ Indirect Costs (cont.)
o Example 2: What are indirect costs for Google Pixel phone?

– Research and Development

– Warranty and Customer Support
– Distribution and Logistics

o Q: (True or False) Google factory managers’ salary is indirect cost regardless of

what the cost object is.
Direct vs Indirect Costs
■ Cost Tracing: Cost Assignment for Direct Costs
■ Cost Allocation: Cost Assignment for Indirect Costs
o Example: Suppose you are a manager of BMW factory running lines such as
BMW X1, X3, X5, X6, and etc., and you want to identify cost of producing X6.
How do you assign costs?
– For direct costs: You will use _________________. Workers submit requisition forms for tires
to manufacture BMW X6s. You can easily identify (trace) the total number of tires used for
manufacturing BMW X6s with these documents (e.g., 4 tires are requested for each car * the
total number of cars manufactured). Direct labor can be tracked by work logs.
– For indirect costs: You will use __________________. Workers need to use electricity to
manufacture a BMW X6 and they do not need to submit any forms for the amount of
electricity they need for each BMW X6. It is more difficult and costly to trace the electricity
for producing BMW X6s. You as a manager would have to use own judgment on how to
allocate the total electricity expenses to the production lines of BMW X6s. You can “allocate”
based on square footage, machine hours, #units produced, etc.
Variable vs Fixed Costs
■ Variable Costs: Costs that vary with the level of activities.
□ What are ‘activities?’ Activities can include manufacturing units
produced, hours worked, units sold, or any other measurable factor that
affects the production or provision of goods and services.
□ Total variable cost (TVC) increases with the level of activities.
□ Unit variable cost (UVC) is constant, regardless of activity level.
o Example: Suppose you want to measure the cost of Airbus A321neo
operated by Cathay Pacific. What are variable costs?

– Fuel
– Maintenance and repairs
– Catering
– Ground handling
Variable vs Fixed Costs
■ Fixed Costs: Costs that do not vary with level of activities.
□ Q: (True or False) Unit fixed cost (UFC) does not vary with level of activities.
o Example: Revisit case of Airbus A321neo operated by Cathay Pacific. What are
fixed costs?

– Aircraft lease
– Depreciation
– Insurance Premiums
– Crew Salaries
Cathay Pacific on recovery track but Chinese rivals loom
The company is "on the track" to recovery, Chairman Patrick Healy said when presenting earnings last week.
Cathay also lowered fixed costs by slashing its workforce to 21,900 employees, down more than 10,000 employees compared with pre-
COVID staffing levels. Rising airfares led to higher per-passenger revenue, contributing to improved earnings. (Nikkei Asia,
2023/08/21)
Cost Drivers and Relevant Range
■ Cost Drivers: Variable that causally affects costs.
□ Cost driver of a variable cost is the level of activity.
□ Cost driver of a fixed cost does not exist in a short run, but may exist in a long run.
o Revisit Cathay Pacific example. What are cost drivers?
– Variable costs:
– Fuel costs: number of flights, flight distance, fuel consumption per flight.
– Maintenance and repairs: Flight hours, cycles of takeoffs and landings.
– Catering: Number of meals served or number of passengers.
– Ground Handling Fees: Number of flights, weight of aircraft.
– Fixed costs:
– Aircraft lease: fixed monthly; but can vary with duration of lease. You can contract 12
month instead of 6 month.
– Depreciation: fixed annually; but can vary with value of aircraft.
– Insurance premiums: vary with value of aircraft.
– Crew salaries: vary with number and type of crew members to operate a specific aircraft.
Cost Drivers and Relevant Range
■ Relevant Range: A range of activities in which variable costs remain variable and
fixed costs remain fixed.
□ If a factory manager monitors the production up to 10,000 units per year, the salary
is fixed within the relevant range of 10,000 units. However, we cannot speak to
how compensation would change outside 10,000 units.
□ Variable costs also have relevant ranges. For example, unit variable costs are
constant only within a relevant range. The unit variable cost could be constant up
to 100 units per year but can change beyond this point.
Cost Drivers and Relevant Range
■ Relevant Range (cont.)
o Revisit Cathay Pacific example. When would costs fall outside the relevant range?
– Variable costs:
– Fuel costs: Fuel price can change due to fuel supply chain disruption.
– Maintenance and repairs: Unexpected technical issues.
– Catering: Sudden changes in passenger demand.
– Ground Handling Fees: Changes in ground handling service provider contracts.
– Fixed costs:
– Aircraft lease: If a company terminates lease agreement earlier, the fixed cost of lease falls
outside the relevant range.
– Depreciation: Useful life can change due to unforeseen technological advancements can
change fixed cost of depreciation.
– Insurance premiums: Change in insured value of aircraft can change fixed cost of
premiums.
– Crew salaries: Downsizing and restructuring can change fixed cost.
Inventoriable vs Period Costs
■ Inventory in Different Sectors
□ Manufacturing: purchase raw materials, convert into finished goods and sell.
o Three types of inventory
– Raw Materials
– Work-in-process: Partially completed
– Finished goods: Completed but not yet sold
o Each type of inventory has its value. How to measure the value of inventory?
– By cost associated with these inventories!
– This cost is called inventoriable cost.
□ Merchandising: purchase and sell tangible products without change basis form.
o Only one type of inventory: Finished Goods
□ Service: provide intangible services.
o No inventory
Inventoriable vs Period Costs
■ Inventoriable Costs (a.k.a. Product Costs): All costs of inventory; costs of either
purchasing or producing goods.
o From Accounting 101, we know inventories are assets on balance sheets (B/S).
o We record these inventoriable costs as assets on B/S.
o What happens if the company sells these inventories?
– From Accounting 101, we learn expense should be matched with revenue!
– We record as Cost of Goods Sold (COGS) on income statement (I/S).
o Three types of inventoriable costs:
– Direct material costs (DM): Cost of acquiring direct raw materials
– Direct labor costs (DL): Compensation paid to labor directly traceable to cost
object.
– Manufacturing overheads (MOH): All other manufacturing costs that cannot be
traced directly or easily.
Inventoriable vs Period Costs
■ Period Costs (a.k.a. Non-inventoriable Costs): Treated as expenses they are
incurred.
o From Accounting 101, we know that expenses are recorded on I/S.
o Example: selling and marketing, administrative, research and development
expenses.

□ Business Functions Related to Each Cost Type in the Value Chain:

Design Production Distributio Customer

R&D Marketing
n Service

Period cost Inventoriable cost Period cost

Are Product Costs and Inventoriable Costs the Same?
□ Strictly speaking, no.
□ Product costs can be defined differently in other purposes.
□ When calculating the cost of inventories, product cost is equal to inventoriable
cost.
□ But for reimbursement from government contracts, which is called cost-plus
agreement, the product cost includes costs associated with R&D, design, and
production.
□ For calculating the overall profitability of product for pricing and product mix
decision, product cost includes all the costs in the value chain.
□ Strictly speaking, product cost is a broader term.

□ In our course, we assume product cost is equal to inventoriable cost because our
primary interest is estimating the cost of inventory.
Various Combination of Cost Terms
■ Let’s suppose Boeing is manufacturing and selling an aircraft called “Boeing 777.” Classify
inventoriable/period costs based on Variable vs Fixed, and Direct vs Indirect cost classification.
□ Inventoriable Cost
Variable Cost Fixed Cost
Direct Cost Aluminum, titanium, composite Fixed salaries of technicians, and
materials, etc. engineers.
Indirect Cost Factory utilities, maintenance and Fixed general factory supplies and
repairs safety equipment.
□ Period Cost
Variable Cost Fixed Cost
Direct Cost Commissions to sales Fixed salaries paid to sales managers or
representatives. marketing executives.
Indirect Cost Office supplies, travel expenses, Salaries of administrative staff, rent for
and legal fees. office buildings, and utilities.
How do Managers Record Costs on Financial Statements?
Tesla Income Statement over 5 years (in $millions)
Year 2023 2022 2021 2020 2019
Revenue 96,773 81,462 53,823 31,536 24,578
Cost of Revenue 79,113 60,609 40,217 24,906 20,509
Gross Profit (Gross Margin) 17,660 20,853 13,606 6,630 4,069
Operating Expenses 8,769 7,197 7,083 4,636 4,138
Operating Income 8,891 13,656 6,523 1,994 -69
Source: Stock Analysis

We need to figure out what COGS and period costs are to estimate operating income.
How do Managers Record Costs on Financial Statements?
DM Available for use

1 = BB (11000) + Purchase of DM (73000) – EB (8000)

=$76000 TMC to account for

3 = BB (6000) + TMC incurred (105000)

- EB (7000) = $104,000

4 Cost of goods
Available for sale

= BB (22000) + COGM (104000)

- EB (18000) = $108,000

5
2 = 210000-108000 =$102,000
= DM used (76000) + DL (9000) + MOH (20000)
= $105,000

Every inventory has the beginning (BB) and ending balance (EB)
We are interested in how much of each inventory flow into
the next process (e.g., DM-> WIP, WIP-> FG)
6
= 210000-108000-70000 =$32,000
How do Managers Record Costs on Financial Statements?
■ Summary of Recording Cost
(1) Direct Material Costs = Beginning Balance of Direct Material (Given)
+ Purchase of New Direct Material (Given)
– Ending Balance of Direct Material (Given)
(2) Total Manufacturing Costs = Direct Material Costs from (1)
+ Direct Labor Costs (Given)
+ Manufacturing Overhead (Given)
(3) Cost of Goods Manufactured = Beginning Balance of Work-in-Process (Given)
+ Total Manufacturing Costs from (2)
– Ending Balance of Work-in-Process (Given)
(4) Cost of Goods Sold = Beginning Balance of Finished Goods (Given)
+ Cost of Goods Manufactured from (3)
– Ending Balance of Finished Goods (Given)
[Practice on Calculation of Costs]
XYZ Manufacturing Company produces widgets. The following information is available for the month of September 2023:

Direct materials purchased: $15,000

Direct labor: $10,000
Factory overhead costs: $6,000
Beginning direct material inventory: $2,500
Ending direct material inventory: $2,500
Beginning work-in-progress inventory: $3,500
Ending work-in-progress inventory: $4,500
Beginning finished goods inventory: $6,000
Ending finished goods inventory: $8,000
Sales revenue: $50,000
Selling and administrative expenses: $4,000
Using the above information, calculate the following:

a) Direct material costs

b) Total manufacturing costs
c) Costs of goods manufactured
d) Costs of goods sold
e) Operating income
[Practice on Calculation of Costs]
Other Cost Terms
■ Mixed costs: costs that have fixed and variable elements.
o Example: Rent = fixed amount + X% of revenue.
■ Prime costs: All direct manufacturing costs; Direct labor cost + direct material cost
o The greater the proportion of prime costs to total costs, the more confident managers
can be about the accuracy of the measured costs of products.
■ Conversion costs: The cost of converting the materials into a finished products; Direct
labor cost + Manufacturing overhead
■ Overtime premium - wages paid in excess of straight-time rates for overtime work
o Indirect overhead
■ Idle time - wages paid for unproductive time caused by lack of orders, machine or
computer breakdown, work delays, poor scheduling, etc
o Indirect overhead
Chapter Summary
□ Cost object is anything managers want to measure.

□ Based on traceability, costs can be classified into direct and indirect costs. Managers trace direct costs while they
allocate indirect costs to cost objects.

□ Based on cost behavior, costs can be classified into variable and fixed costs. Total variable cost increases with level of
activity while unit variable cost remains constant. Total fixed cost remains constant while unit fixed cost decreases
with level of activity. Cost drivers exist for variable costs while they don’t exist for fixed costs within a relevant range.
Cost behaviors change outside the relevant range.

□ Based on whether costs can be assets, costs can be classified into inventoriable and period costs. Inventoriable costs
are recorded as assets on B/S and recorded as COGS once inventories are sold. Inventoriable costs can be further
classified into direct material cost, direct labor cost, and manufacturing overhead. Period costs are expensed on I/S.

□ These cost terms above are not mutually exclusive and costs can be classified into various combination of cost terms.

□ Students need to know how to solve direct material cost, total manufacturing cost, cost of goods manufactured, cost of
goods sold, and operating income.