BUS 322: Intermediate Management Accounting II Week2: Class Notes

Chapter2-The introduction to Cost terms and purposes

Learning Outcomes

1. Identify and distinguish between two manufacturing cost classification systems: direct and
indirect, prime and conversion
2. Differentiate fixed from variable cost behavior, and explain the relationship of cost
behavior to direct and indirect classifications
3. Interpret unitized fixed costs appropriately when making cost management decisions
4. Apply cost information to produce a GAAP-compliant statement of comprehensive income
showing proper cost of goods sold and a statement of financial position showing proper
inventory valuation
5. Explain cost identification, classification, and management systems and their use within the
decision framework
1. Cost and Cost Terminology
Cost is a resource sacrificed or foregone to achieve a specific objective. It is measured as the
monetary amount that must be paid to acquire goods or services.
An actual cost has been incurred in the past (historical).
A budgeted cost is expected or predicted to occur in the future (forecast).
Cost object, anything for which a measurement of costs is desired.
Cost accumulation is the collection (accumulation) of actual cost data in an organized way.
Management accountants refer to accumulated costs as cost pools. This is not to be confused with
what financial accountants collect in general ledger accounts, though on first glance they appear
the same.
Cost assignment systematically links a pool of actual costs to a distinct cost object.

A. Direct and Indirect Costs

Direct costs of a cost object are related to the distinct cost object and can be traced to it in a cost-
effective way using manual or electronic documentation.
Indirect costs of a cost object are necessary but cannot be traced to a specific cost object in a
cost-effective way because the benefits from use of the resources are shared among diverse cost
objects.
Typical indirect manufacturing costs are often referred to as manufacturing overhead (MOH)
Upstream costs are costs incurred prior to production.
Downstream costs are costs incurred after production.
Cost assignment is a general term that encompasses both;
1. Tracing direct costs to a distinct cost object.
2. Allocating indirect costs among diverse cost objects.

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BUS 322: Intermediate Management Accounting II Week2: Class Notes

An example of upstream, production, and downstream direct and indirect costs with both forms
of cost assignment: cost tracing and cost allocation.

B. Factors Affecting Direct/Indirect Cost Classifications

Balancing several factors that influence cost classification requires professional judgment:
• Selection of the distinct cost object
• The materiality of significance of the cost in question
• Available information-gathering technology
• Design of operations.

C. Prime Costs and Conversion Costs

The process framework or logic partitions all inventoriable costs into either of two classifications,
prime or conversion
1. Prime costs are the most significant costs of inputs. Usually direct materials is the most
significant single cost in the process costing system. Direct manufacturing labor can be
significant enough to be included in prime cost.
2. Conversion costs include immaterial amounts of labor and all the other costs necessary to
complete a large number of units of output flowing through a manufacturing process where
one unit of output is not distinguishable from another unit.
This classification aids management in monitoring and controlling the costs and to predict profit
performance. This method of cost capturing and allocating costs works best when the company is
mass producing a homogeneous product.
2. Cost-Behavior Patterns: Variable Costs and Fixed Costs
a. Variable Costs
A variable cost (VC) changes in proportion to changes in the related level of total activity or
volume within a relevant range, because the cost per unit is constant. Relevant range is the
range applicable to the variable cost determined by observation and experience. The level of
production is where the cost per unit remains constant. Anything below or above that range
will likely cause a change in the cost per unit.
b. Fixed Costs
Fixed cost is constant within a relevant range of finished outputs produced. However, when
expressed on a per-unit basis, fixed costs would decline with an increase in activity.
Mixed costs pool comprises both variable and fixed costs.

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BUS 322: Intermediate Management Accounting II Week2: Class Notes

c. Relationship Among Cost Classifications and Cost Behavior

Costs are not inherently fixed or variable; it depends on the defined cost object. They may be
variable with respect to level of activity and fixed for another.
d. Cost Drivers
A cost driver is a variable, such as the level of activity or volume that causally affects costs
over a given time span. There is a cause-and-effect relationship between the level of activity
of the cost driver and the cost incurred.
Multiple Choice Quiz
Multiple Choice Questions 1 to 3.
Practice Question:
In class Example 1
Assigned Question 1
3. Interpreting Unitized Fixed Costs
Failure to understand the variability of unitized cost rates causes poor decisions.
4. Cost of Goods Sold and The Statement of Comprehensive Income

Cost of goods manufactured (COGM) is the cost of producing the total volume of finished
goods in a specific time periods, both sold and unsold.
On the statement of comprehensive income, the cost of goods sold (COGS) must be reported in
compliance with GAAP. GAAP rules on inventory and COGS for Canadian companies trading
on the Toronto Stock Exchange (TSX) are identical whether finished goods are produced in
Canada, the US, or Europe.]

By summing unitized costs throughout the value chain, managers calculate the total unitized cost
of each product or service they deliver and determine the profitability of each product or service
at full cost.
a. Inventory Valuation and the Statement of Financial Position
There are three economic sectors in which businesses operate:
i.Manufacturing-sector companies
ii.Merchandising-sector companies
iii.Service-sector companies
Inventoriable costs – are considered assets, and methods of classification are defined by GAAP.
Unless the business engages in manufacturing, it will have no inventoriable costs. If no finished
goods are sold, then all manufacturing costs are costs of goods available for sale.
b. Types of Inventory
The accounting system of a manufacturing company is more complex than for a merchandising or
service company. The main reason for this complexity is in the inventories held by a
manufacturer. These companies will have three types of inventory.
1. Direct material inventory (DM) or simply Materials Inventory, consists of materials
being held by the company, ready to begin the conversion process into a finished product
2. Work-in process inventory (WIP) represents product partially worked on but not yet
completed. WIP is a representation of what is on the factory floor.

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BUS 322: Intermediate Management Accounting II Week2: Class Notes

3. Finished goods inventory (FG) is product that has been completed and has not yet been
sold.
Merchandising companies purchase products in their completed form and do not make changes in
their basic form. An inventory account for a merchandising company is called Merchandise
Inventory.
c. Commonly Used Classifications of Manufacturing costs
Three terms commonly used when describing manufacturing costs are direct material costs,
direct manufacturing labour costs, and indirect manufacturing costs.

1. Direct material costs are the costs of materials that become part of the cost object and can
be traced to the cost object in an economically feasible manner.
2. Direct manufacturing labour costs include compensation of manufacturing labour that
can be traced to the cost object in an economically feasible manner. This includes labour of
workers who work directly on the product.
3. Indirect manufacturing costs are all manufacturing costs that are not direct materials or
direct labour. These costs are allocated rather than traced. Other terms for this category
include manufacturing overhead or factory overhead costs.
d. Inventoriable Costs
Inventoriable costs are all costs of a product that are considered assets on the statement of
financial position. These costs are direct materials, direct labour, and factory overhead. They
become a part of the cost of the product and are assets until sold, when they become cost of goods
sold. These are also known as product costs.
e. Period Costs
Period costs are all costs on the statement of comprehensive income other than cost of goods
sold. Period costs are treated as expenses of the period in which they are incurred. They are also
referred to as upstream and downstream costs, non-manufacturing costs, operating expenses and
non-inventoriable costs. According to GAAP, period costs are expensed when incurred.
f. Illustrating The Flow of Inventoriable Costs: a Manufacturing-Sector Example
Interest expense is incurred during a specific time period, but it is a financing, not an operating,
cost. The value-chain business functions exclude finance decisions. Finance decisions are closely
coordinated with strategic and operating decisions, including production. Similarly, tax expense is
not an operating expense despite being a period cost. It is a regulatory cost of doing business in
any country.
g. Inventoriable Costs and Period Costs For a Merchandising Company
Inventoriable costs and period costs flow through the statement of comprehensive income at a
merchandising company similarly to the way costs flow at a manufacturing company. A
merchandising-sector company also has a variety of period costs, such as marketing, distribution,
and customer-service costs. In an statement of comprehensive income, period costs are deducted
from revenues without ever having been included as part of inventory.

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BUS 322: Intermediate Management Accounting II Week2: Class Notes

Schedule of Cost of Goods Manufactured and Sold

Beginning direct materials inventory

+ Purchases___________________
Available for use

− Ending direct materials inventory__

Direct materials used

Direct manufacturing labour

Indirect manufacturing costs (Listing)

Variable
Fixed
Total Manufacturing costs incurred during current period

Schedule of Cost of Goods Sold

+ Beginning work in process inventory

Total manufacturing costs to account for

− Ending work in process inventory

Cost of goods manufactured

+ Beginning finished goods inventory

Goods available for sale

− Ending finished goods inventory__

Cost of goods sold (to the statement of comprehensive income)

Statement of Comprehensive Income

Revenue (Sales)
− Cost of goods sold (from the schedule)
Gross margin
− Operating costs
Operating income

Multiple choice Quiz

Multiple Choice questions 4, 5,7,8, 9
Practice Questions
In class Example 2
Assigned Question 2
Assigned Question 3
Assigned Question 4

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BUS 322: Intermediate Management Accounting II Week2: Class Notes

5. Measuring and Classifying Costs Requires Judgment

Costs can be defined and classified in alternative ways. Different companies and even
different subunits within the same company may define and classify the same costs
differently. Definition and classification of costs depends on the decision that needs to be
made, the cost object, and the company.
a. Measuring Labour Costs
Although manufacturing labour cost classifications vary among companies, most companies
have a list of categories. The list includes a variety of hourly wage and salaried indirect
labour. Indirect labour costs comprise a wide range of hourly wages, which are variable
costs, plus statutory benefits.
It is important to be alert regarding whether or not these costs are classified as indirect
manufacturing costs because there is some flexibility in GAAP when including costs in
COGM and COGS. Management salaries may legitimately be classified as operating
expenses when plant managers also spend time doing overall corporate work. This flexibility
means the gross margin and gross margin percentage will differ among similar companies
depending on how factory management salaries are classified.
Two issues in cost measurement that require special attention are idle time and overtime
premium. Idle time are wages paid for unproductive time caused by such events as lack of
orders or machine breakdowns. Overtime premium is the wage rate paid to workers in
excess of their regular straight-time wage rate. Both of these are considered as overhead
rather than direct labour costs.
b. Decision Framework and Flexibility of Costing Methods
Product cost is the sum of the costs assigned to a product to make a specific decision.
Different decisions often require different measures of product cost.
i. Pricing and product-mix decisions – decisions require an emphasis on the total
profitability of different products and would assign costs incurred in all business
functions to the product.
ii. Contracting with government agencies. Government contracts often reimburse
contractors on the basis of the cost plus a specific markup percentage. Government will
clearly state all eligible and ineligible costs. Some contracts explicitly exclude non-
manufacturing costs, while others include only a few of the costs in the value chain.
iii. Preparing financial statements for external reporting under GAAP. Under GAAP,
only manufacturing costs can be assigned to inventories in the financial statements. For
the purpose of calculating inventory costs and COGS, product costs include only
inventoriable (manufacturing) costs.
Multiple choice Quiz
Multiple Choice questions 6, 10
Practice Question:
In class Example 3
In class Example 4

MyLab Accounting: Ch2- Practice Questions