Managerial Accounting

Session 2
Basic Cost Concepts &
Classifications

Ng Eng Wan
FCPA CIA ACMA CGMA
Learning Objectives (1 of 2)
•
2.1 Distinguish among service, merchandising, and
manufacturing companies
•
2.2 Describe the value chain and its elements
•
2.3 Distinguish between direct and indirect costs
•
2.4 Identify product costs and period costs
•
2.5 Prepare the financial statements for service,
merchandising, and manufacturing companies
Learning Objectives (2 of 2)
•
2.6 Describe costs that are relevant and irrelevant for
decision making
•
2.7 Classify costs as fixed or variable and calculate total
and average costs at different volumes
•
2.8 Learn the 4 types of quality costs
Summary of Cost
Classifications
Learning Objective 1

Distinguish among service,

merchandising, and manufacturing
companies
Most Common Business
Sectors
• Service companies
• Merchandising companies
• Manufacturing companies
Service Companies

• Sell intangible services

• Ex: health care, insurance, banking, and
consulting
• Largest sector of U.S. economy
• Generally, no inventory
Merchandising Companies
• Resell tangible products bought from
manufacturers and suppliers
• Ex: Walmart and Best Buy
• Retailers vs. Wholesalers
• Carry substantial amount of inventory
Manufacturing Companies
• Use labor, plant, and equipment to convert
raw materials into finished products
• Ex: Toyota
• Three types of inventory
• Raw materials inventory
• Work in process inventory
• Finished goods inventory
Service, Merchandising,
and Manufacturing
Companies
Learning Objective 2

Describe the value chain and its

elements
The Value Chain
The activities that add value to the company’s
products and services
Elements of the Value
Chain (1 of 2)
• Research and Development (R&D): researching
and developing new or improved products services
and the processes for producing them
• Design: detailed engineering of products and
services and the processes for producing them
• Production or Purchases: resources used by
manufacturers to produce a product or
merchandising companies purchasing finished
merchandise for resale
Elements of the Value
Chain (2 of 2)
• Marketing: promotion and advertising of products
or services
• Distribution: delivery of products or services to
customers
• Customer Service: support provided for customers
after sale
Learning Objective 3

Distinguish between direct and

indirect costs
Cost Objects
• Anything for which managers want to know
the cost
• Ex: Toyota’s cost objects may include:
• Individual units
• Different models
• Alternative marketing strategies
• Geographic business segments
• Departments
• Sustainability initiatives
Direct and Indirect Costs
• Direct cost: cost that can be traced to the
cost object
• Readily associate the cost with the cost object

• Indirect cost: cost that relates to the cost

object but cannot be traced specifically to it
• Jointly used among several cost objects
Assigning Direct and
Indirect Costs to Cost
Objects
Assigning Costs to Cost Objects
Direct costs Indirect costs
• Costs that can be • Costs that cannot be
easily and conveniently easily and conveniently
traced to a unit of traced to a unit of
product or other cost product or other cost
object. object.
• Examples: direct • Example: manufacturing
material and direct overhead
labor
Learning Objective 4

Identify product costs and period

costs
Costs for Internal Decision
Making
• Consider all costs incurred across the value
chain
• Total cost: all resources used throughout the
value chain
• Must ensure price covers all costs plus
returns a profit
Costs for External
Reporting
• Must follow GAAP
• Product costs: incurred by manufacturers to
produce their products or by merchandisers to
purchase their products
• Relate to obtaining inventory
• Period costs: do not get treated as inventory,
immediately expensed
• Incurred in other functions of the value chain
• “Operating expenses” or “Selling, general, and
administrative expenses”
Total Costs, Product Costs,
and Period Costs
COGS / COS
• Shoe retailer
• Bought 10 pairs of shoes cost $100 each
• Shop rent $ 200
• Shop assistant $ 150
• Sold 7 pairs of shoes at $ 150 each
• Sales revenue = $150 * 7 = $1,050
• COGS = $100*7 = $700
• Gross profit = Sales revenue – COGS = $350
• Operating expenses = $200 + $150 = $ 350
• Ending inventory = $100*3 = $300
24
Merchandising Companies’
Total Costs
Manufacturing Companies’
Product Costs (1 of 2)
Manufacturing Companies’
Product Costs (2 of 2)
• Direct Materials (DM): primary materials that
become the physical part of the finished
product
• Direct Labor (DL): cost of compensating
employees who physically convert raw materials
into the company’s product
• Manufacturing Overhead (MOH): all
manufacturing costs other than DM and DL
• Indirect materials, indirect labor, and indirect
manufacturing costs
Summary of a
Manufacturing Company’s
Total Costs
Exercise
Prime and Conversion
Costs
Learning Objective 5

Prepare the financial statements for

service, merchandising, and
manufacturing companies
Service Company Income
Statement
Merchandising Company
Income Statement
Cost of Goods Sold—
Merchandising Company
Manufacturing Company
Income Statement
Calculating Cost of Goods
Sold—Manufacturer (1 of 3)
Step 1: Calculate the cost of direct materials used
Calculating Cost of Goods
Sold—Manufacturer (2 of 3)
Step 2: Calculate the cost of goods manufactured
Calculating Cost of Goods
Sold—Manufacturer (3 of 3)
Step 3: Calculate the cost of goods sold
Comparing Balance Sheets
• The only difference relates to how inventory
is shown in the current asset section:
• Service companies have no inventory.
• Merchandising companies show Inventory or
Merchandise Inventory.
• Manufacturing companies show Raw Materials,
Work in Process, and Finished Goods Inventory.
Learning Objective 6

Describe costs that are relevant and

irrelevant for decision making
Controllable Versus
Uncontrollable Costs
• Controllable Costs: management is able to
influence or change
• Uncontrollable Costs: costs companies are
locked in to in the short run
Relevant and Irrelevant
Costs
• Relevant costs: differential costs, differ
between alternatives
• Irrelevant costs: do not differ among
alternatives
• Sunk costs: costs that have already been
incurred and cannot be changed
Quick Check 
Suppose you are trying to decide whether to
drive or take the train to Kuala Lumpur to attend
a concert. You have ample cash to do either, but
you don’t want to 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 you are trying to decide whether to drive or
take the train to Kuala Lumpur 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 Kuala
Lumpur?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.
Sunk Costs
Sunk costs have already been incurred and cannot be
changed now or in the future. These costs 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.
Learning Objective 7

Classify costs as fixed or variable and

calculate total and average costs at
different volumes
Fixed Costs
Stay constant in total over a wide range
of activity levels but increases or
decreases inversely with changes in
activity
Variable Costs
Change in total in direct proportion to
changes in volume but constant if
expressed on a per unit basis
 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.
How Manufacturing Costs
Behave
Total Cost
Total cost = Total fixed cost + (Variable
cost per unit x Number of units)
• Example
• Fixed costs = $20,000,000
• Variable cost per unit = $5,000 per vehicle
• Number of units = 10,000 vehicles
$20,000,000 + ($5,000 x 10,000) = $70,000,000
Average Cost
Average cost = Total cost ÷ Number of units
• Example
• Total cost = $70,000,000 (from prev. slide)
• Number of units = 10,000 vehicles
$70,000,000 = $7,000 per vehicle
10,000
Marginal Cost
• The cost of making one more unit.
• Fixed costs will not change if one more unit is
made, unless the plant is already operating
at 100% capacity.
Learning Objective 8

Learn the 4 types of quality costs

Quality of Conformance

When the overwhelming majority of products

produced conform to design specifications and are
free from defects.
Quality Costs
- cost of preventing, detecting and dealing with defects

Prevention Costs Internal Failure Costs

Appraisal Costs External Failure Costs

Prevention and Appraisal
Costs
Support activities whose
Prevention Costs purpose is to reduce the
number of defects

Incurred to identify
defective products
Appraisal Costs before the products are
shipped to customers
 Examples of Quality Costs
Prevention Costs
• Quality training
• Quality circles
• Statistical process
control activities

Appraisal Costs
• Testing and inspecting
incoming materials
• Final product testing
• Depreciation of testing
equipment
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
Internal Failure Costs
• Scrap
• Spoilage
• Rework

External Failure Costs

• Cost of field servicing and
handling complaints
• Warranty repairs
• Lost sales
Exercises & Problems
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.
B. $ 800. $1,000 + $100 = $1,100
C. $1,200. $1,100 - $300 = $800
D. $ 200.
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
Beg.
Beg. raw
raw materials
materials $
$ 32,000
32,000
B. $272,000 ++ Raw
Raw materials
materials
purchased
purchased 276,000
276,000
C. $280,000 == Raw
Raw materials
materials available
available
for
for use
use in
in production
production $$ 308,000
308,000
D. $ 2,000 –– Ending
Ending raw
raw materials
materials
inventory
inventory 28,000
28,000
=
= Raw
Raw materials
materials used
used
in
in production
production $
$ 280,000
280,000
Quick Check 
Direct materials used in production totaled
$280,000. Direct labor was $375,000 and factory
overhead was $180,000. What were total
manufacturing costs incurred for the month?
A. $555,000
B. $835,000
C. $655,000
D. Cannot be determined.
Quick Check 
Direct materials used in production totaled
$280,000. Direct labor was $375,000 and factory
overhead was $180,000. What were total
manufacturing costs incurred for the month?
A. $555,000
B. $835,000
C. $655,000
D. Cannot be determined.
Direct
Direct Materials
Materials $$280,000
280,000
+
+ Direct
Direct Labor
Labor 375,000
375,000
+
+ Mfg.
Mfg. Overhead
Overhead 180,000
180,000
=
= Mfg.
Mfg. Costs
Costs Incurred
Incurred
for
for the
the Month
Month $
$835,000
835,000
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
D. Cannot be determined.
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
Beginning work in
process inventory $ 125,000
during the month? + Mfg. costs incurred

A. $1,160,000 = Total work in process

for the period 835,000

B. $ 910,000 – Endingduring the period

work in
$ 960,000

C. $ 760,000 = Costprocess inventory

of goods
200,000

D. Cannot be determined.
manufactured $ 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.
B. $740,000.
C. $780,000. $130,000 + $760,000 = $890,000
$890,000 - $150,000 = $740,000
D. $760,000.
Which of the following types of companies would have
work in process inventory?

a. Service
b. Merchandising
c. Manufacturing
d. All of the above
Which of the following is NOT part of
manufacturing overhead?
a. Period costs, such as depreciation on office
computers
b. Indirect materials, such as machine lubricants
c. Indirect labor, such as forklift operators’ wages
d. Other indirect manufacturing costs, such as
plant utilities
Which of the following types of companies will always
have the Cost of Goods Sold account on their income
statement?
a. Service and merchandising companies
b. Merchandising and manufacturing companies
c. Service and manufacturing companies
d. Service, merchandising, and manufacturing
companies
Which of the following is false?
a. Uncontrollable costs are costs over which the
company has little or no control in the short run.
b. Sunk costs are costs that have already been
incurred.
c. Sunk costs are generally relevant to decisions.
d. The difference in cost between two alternatives
is known as a differential cost.
Which of the following is true?
a. The average cost per unit can be used for
predicting total costs at many different output
levels.
b. Manufacturing overhead is composed of only
variable costs.
c. Fixed costs stay constant in total over a wide
range of activity levels.
d. Direct materials are considered to be fixed costs.