Chapter 2:

Cost Terminology and

Cost Behaviors

Cost Accounting:
Foundations & Evolutions, 9e

Kinney and Raiborn

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Learning Objectives
 Why are costs associated with a cost object?
 What assumptions do accountants make about cost
behavior, and why are such assumptions
necessary?
 How are costs classified on financial statements,
and why are such classifications useful?
 How does the conversion process occur in
manufacturing and service companies?
 What are the product cost categories, and what
items comprise those categories?
 How and why does overhead need to be allocated
to products?
 How is cost of goods manufactured calculated and
used in preparing an income statement?
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Cost Categories
 Association with cost object
 Cost object is anything for which management wants to collect
or accumulate costs
 Reaction to changes in activity
 Classification on the financial statements

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Cost Categories
 Association with cost object
 Direct—traceable to a cost object
 Indirect—not conveniently or practically
traceable to a cost object
 treated as overhead
 allocated

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Cost Categories
 Association with cost object
 Reaction to changes in activity
 Variable
 Fixed
 Mixed
 Step

Relevant Range—normal operating range

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 Total and Unit Cost Behavior
Total Cost Unit Cost

Varies in direct Remains constant

Variable proportion to throughout the
Cost changes in activity relevant range

Fixed Remains constant Varies inversely

Cost throughout with changes in
the relevant range activity throughout
the relevant range

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Cost Categories
 Classification on the financial statements
 Unexpired—balance sheet assets
 Expired—income statement expenses
 Product—inventoriable costs
 Prime—direct material and direct labor
 Conversion—direct labor and overhead
 Product costs are unexpired before sale
 Product costs are expired when sold
 Period—expensed in period incurred

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Product Costs
 Direct material
 Measurable part of a product
 Direct labor
 Labor used to manufacture a product or
perform a service
 Overhead
 Indirect production cost

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Period Costs
 Selling and administrative costs
 Distribution costs
 Cost to warehouse, transport, and/or deliver a
product or service
 Major impact on managerial decision making

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 Conversion Process
Change Inputs into Outputs
Input Output
Purchase
raw materials Product or
or supplies Service

CONVERSION

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 Cost Accumulation in a
Manufacturing Company
Materials
Inventory

Work in Process
Inventory
Finished Cost of
Goods Goods
Inventory Sold
Income
Balance Sheet Statement
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 Product Cost – Direct
 Direct Material
 Conveniently and economically traced
to cost object
 Direct Labor
 to manufacture a product or perform a service
 includes wages paid to direct labor employees,
production bonuses, and payroll taxes
 may include holiday and vacation pay,
insurance, and retirement benefits

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Product Cost – Indirect

 Overhead—indirect production costs

 Fringe benefits, if cannot be easily traced to
product
 Overtime, if due to random scheduling
 Cost of quality
 Prevention costs
 Appraisal costs
 Failure costs

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Product Cost Behavior

 Direct Material Variable

 Direct Labor Variable

 Overhead Variable, fixed, or mixed

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Overhead Cost Allocation
Assign indirect costs to one or more cost objects

 To determine full absorption cost (GAAP)

 To motivate management
 To compare alternative courses of action for
planning, controlling, and decision making

Allocation process should be rational and systematic

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 Allocating Overhead
Actual vs. Normal
Product Cost Actual Cost Normal Cost
System System
Direct Materials Actual Actual

Direct Labor Actual Actual

Overhead Actual Predetermined

Overhead Rate

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Predetermined Overhead Rate

 Allows overhead to be assigned

during the period
 Compensates for fluctuations
 that are not related to activity level
 in activity level that do not affect fixed
overhead

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Questions

 What is the difference between a fixed and

variable cost?
 What are the three components of product
cost?
 What are the three inventory accounts for a
manufacturing company?

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Ethical Issues

 Expired costs—not on the balance sheet

 Period costs—not inventory
 Product costs—not selling or administrative
costs
 Direct labor—not overstated
 Ending inventory—not overstated

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