Overview managerial accounting chapter 02

Define and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.. Because of inventories, the cost of goods sold for a p

Chapter 2 Cost Terms, Concepts, and Classifications

Learning Objectives

LO1 Identify and give examples of each of the three basic manufacturing cost categories LO2 Distinguish between product costs and period costs and give examples of each

LO3 Prepare an income statement including calculation of the cost of goods sold

LO4 Prepare a schedule of cost of goods manufactured

LO5 Understand the differences between variable costs and fixed costs

LO6 Understand the differences between direct and indirect costs

LO7 Define and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs

LO8 (Appendix 2A) Properly account for labor costs associated with idle time, overtime, and fringe benefits

LO9 (Appendix 2B) Identify the four types of quality costs and explain how they interact LO10 (Appendix 2B) Prepare and interpret a quality cost report

New in this Edition

• Many new In Business boxes have been added

• New shorter exercises that cover a single learning objective have been created

Chapter Overview

A General Theme. Costs can be classified in a number of ways—depending on the purpose

of the classification For example, classification of costs for purposes of determining inventory valuations and cost of goods sold for external reports differs from the classification of costs that would be carried out to aid decision-making It is important to note that the classifications of costs are not mutually exclusive That is, a particular cost may be classified in many different ways—depending on the purpose of the classification

B Cost Classifications for Preparing External Financial Statements. (Exercises 2-1, 2-2, 2-3, 2-4, 2-10, 2-11, and 2-12.) This section of the chapter focuses on the problem of valuing inventories and determining cost of goods sold for external financial reports Before beginning this discussion, you may want to explain the difference between a manufacturing and

a merchandising company Manufacturing companies convert raw materials into a product The company then sells that product either to other companies or, less commonly, directly to individuals “Manufacturing” includes restaurants, movie studios, and other service-type companies as well as the more obvious examples of manufacturing such as automobile and clothing production Merchandising companies, by contrast, buy finished products and resell the products to customers Valuing inventories and determining cost of goods sold is simple in a merchandising company, but is difficult in a manufacturing company For that reason, we concentrate on manufacturing in this section of the chapter

1 Manufacturing costs These costs are incurred to make a product Manufacturing costs are

usually grouped into three main categories: direct materials, direct labor, and manufacturing overhead

a Direct materials Direct materials consist of those raw material inputs that become an integral part of a finished product and can be easily traced into it Examples include the aircraft engines on a Boeing 777, the Intel processing chip in a personal computer, and the blank video cassette in a pre-recorded video

b Direct Labor Direct labor consists of that portion of labor cost that can be easily traced

to a product Direct labor is sometimes referred to as “touch labor” since it consists of the costs of workers who “touch” the product as it is being made

c Manufacturing Overhead Manufacturing overhead consists of all manufacturing costs other than direct materials and direct labor These costs cannot be easily and conveniently traced to products Examples include miscellaneous supplies such as rivets in a Boeing 777, supervisors, janitors, factory facility charges, etc

d Prime versus Conversion Costs Prime cost consists of direct materials plus direct labor Conversion cost consists of direct labor plus manufacturing overhead

2 Non-manufacturing costs A manufacturing company incurs many other costs in addition

to manufacturing costs For financial reporting purposes most of these other costs are typically classified as selling (marketing) costs and administrative costs Marketing and administrative costs are incurred in both manufacturing and merchandising firms

a Marketing Costs These costs include the costs of making sales, taking customer orders, and delivering the product to customers These costs are also referred to as order-getting and order-filling costs

b Administrative Costs These costs include all executive, organizational, and clerical costs that are not classified as production or marketing costs

3 Period vs product costs Costs can also be classified as period or product costs

a Period Costs Period costs are expensed in the time period in which they are incurred All selling and administrative costs are typically considered to be period costs You should be careful to point out that the usual rules of accrual accounting apply For example, administrative salary costs are “incurred” when they are earned and not necessarily when they are paid to employees

b Product Costs Product costs are added to units of product (i.e., “inventoried”) as they are incurred and are not treated as expenses until the units are sold This can result in a delay of one or more periods between the time in which the cost is incurred and when it appears as an expense on the income statement Product costs are also known as inventoriable costs The discussion in the chapter follows the usual interpretation of GAAP in which all manufacturing costs are treated as product costs

4 Inventory valuations and Cost of Goods Sold In a manufacturing company, raw

materials purchases are recorded in a raw materials inventory account These costs are

transferred to a work in process inventory account when the materials are released to the production departments Other manufacturing costs—direct labor and manufacturing overhead—are charged to the work in process inventory account as incurred As work in process is completed, its costs are transferred to the finished goods inventory account These costs become expenses only when the finished goods are sold Period expenses are taken directly to the income statement as expenses of the period

5 Schedule of Cost of Goods Manufactured Because of inventories, the cost of goods sold

for a period is not simply the manufacturing costs incurred during the period Some of the cost of goods sold may be for units completed in a previous period And some of the units completed in the current period may not have been sold and will still be on the balance sheet as assets The cost of goods sold is computed with the aid of a schedule of costs of goods manufactured, which takes into account changes in inventories The schedule of cost

of goods manufactured is not ordinarily included in external financial reports, but must be compiled by accountants within the company in order to arrive at the cost of goods sold You should take some time to explain the cost of goods manufactured schedule since it is often difficult for students to understand

C Cost Classifications to Describe Cost Behavior. (Exercises 2-5 and 2-11.) Managers often need to be able to predict how costs will change in response to changes in activity The activity might be the output of goods or services or it might be some measure of activity internal

to the company such as the number of purchase orders processed during a period In this chapter, nearly all of the illustrations assume that the activity is the output of goods or services In later chapters, other measures of activity will be introduced

While there are other ways to classify costs according to how they react to changes in activity, in this chapter we introduce the simple variable and fixed classifications A variable cost is constant per unit of activity but changes in total as the activity level rises and falls A fixed cost is constant in total for changes in activity within the relevant range (Just about any cost will change if there is a big enough change in activity Fixed costs do not change for changes in activity that fall within the “relevant range.”) When expressed on a per unit basis, a fixed cost is inversely related to activity—the per unit cost decreases when activity rises and increases when activity falls

There is some controversy concerning the proper definition of the “relevant range.” Some refer to the relevant range as the range of activity within which the company usually operates

We refer to the relevant range as the range of activity within which the assumptions about variable and fixed costs are valid Either definition could be used—our choice was dictated by our desire to highlight the notion that fixed costs can change if the level of activity changes enough

D Cost Classifications for Assigning Costs. (Exercise 2-6.) Managers often want costs

to be assigned to “cost objects” such as products, customers, departments, etc for pricing or other purposes A direct cost is a cost that can be conveniently and easily traced to a particular cost object Indirect costs are everything else A cost would be considered indirect for one of two

reasons: either it is impractical or it is impossible to trace the cost to the cost object

1 Common costs For example, it is impossible to trace the factory managers’ salary in a

multi-product plant to any particular product made in the plant Even if a product were dropped entirely, we would ordinarily expect the factory manager’s salary to remain the same This is an example of a “common cost” and later in the text we emphasize that such costs should not be allocated for decision-making or performance evaluation purposes

2 Variable indirect costs On the other hand, other costs are treated as indirect costs because

it would not be practical to treat them otherwise For example, it would be possible to measure the precise amount of solder used on each circuit board produced at a HP plant, but it wouldn’t be worth the effort Instead, solder would typically be considered an indirect material and would be included in overhead

E Cost Classifications for Decision-Making. (Exercise 2-7.) Every decision involves choosing from among at least two alternatives Only those costs and benefits that differ between alternatives are relevant in making the selection This concept is explored in greater detail in the chapter on relevant costs However, decision-making contexts crop up from time to time in the text before that chapter, so it is a good idea to familiarize students with relevant cost concepts

1 Differential Costs A differential cost is a cost that differs between alternatives The cost

may exist in only one of the alternatives or the total amount of the cost may differ between the alternatives In the latter case, the differential cost would be the difference between the cost under one alternative and the cost under the other Differential costs are also called incremental costs Differential costs and opportunity costs should be the focus of decision-making They are the only relevant costs and all others should be ignored

2 Opportunity Costs An opportunity cost is the potential benefit that is given up by

selecting one alternative over another The concept of an opportunity cost is rather difficult for students to understand because it is not an actual expenditure and it is rarely (if ever) shown on the accounting books of an organization It is, however, a cost that must be considered in decisions

3 Sunk Cost A sunk cost is a cost that has already been incurred and that cannot be changed

by any decision made now or in the future Since sunk costs cannot be changed and therefore cannot be differential costs, they should be ignored in decision making While students usually accept the idea that sunk costs should be ignored on an abstract level, like most people they often have difficulty putting this idea into practice

F Classification of Labor Costs (Appendix 2A). (Exercises 2-8 and 2-13.) Factory labor costs are classified as direct or indirect labor Direct labor is basically “touch labor.” Indirect labor is the rest of the manufacturing labor cost and it is classified as part of manufacturing overhead Examples of indirect labor include the wages and salaries of janitors, supervisors, material handlers, and maintenance workers

1 Idle Time Some labor costs, such as idle time, are not easily identified as either direct or

indirect labor Idle time represents the wages of direct labor workers who are idle due to machine breakdowns, material shortages, and so forth Typically, these costs are classified

as overhead costs and are allocated across all products

2 Overtime Premium The overtime premium paid to factory workers is usually considered

to be part of manufacturing overhead It is argued that it would be unfair to charge an overtime premium against a product that happened to be scheduled for the overtime period Therefore, the overtime premium is usually added to overhead and spread among all jobs of the period It should be noted that if a company works overtime specifically because of a special request or a rush order job, the overtime premium may appropriately be charged against that particular job

3 Fringe Benefits These costs include payments made to insurance and retirement plans as

well as various employee taxes such as social security Typically, companies treat these costs as manufacturing overhead However, it would be more accurate to split fringe benefits between the portion that relates to direct labor and the portion that relates to indirect labor Only those fringe benefits that relate to indirect labor should be included in manufacturing overhead; the rest should be considered as part of direct labor cost

G Quality Costs (Appendix 2B) (Exercise 2-9.) The term quality has many meanings Quality can mean that a product has many features not found in other products; it can mean that

it is well-designed; or it can mean that it is defect-free In this appendix, the focus is on the

presence or absence of defects Quality of conformance is the degree to which the actual product

or service meets its design specifications Anything that does not meet design specifications is a defect and is indicative of low quality of conformance

1 Costs of Internal and External Failure The costs of not meeting design specifications

are classified as internal failure costs and external failure costs Defects that are detected internally result in costs such as scrap or rework Defective units that are released to customers create external failure costs Examples of external failure costs include customer returns and exchanges, repairs under warranties, product recalls, and lost sales due to a reputation for selling defective products

2 Costs of Reducing Defects There are basically only two ways to reduce defects and the

resulting costs of internal and external failures Either the defects can be prevented or they can be detected and corrected

a Defects can be prevented by designing products that are “robust;” that is, that are not sensitive to variations and errors in the production process Defects can also be prevented by improving production processes Statistical process control has been especially useful in driving variation out of production processes and thereby reducing defect rates Most experts believe that until the late 1980s too little attention was paid

in the United States to prevention Instead, reliance was placed on detecting defects once they had occurred

b Defective units can be detected before they are delivered to customers by inspecting and testing units throughout the production process This approach to reducing defects

is expensive since it involves inspection labor and testing equipment Moreover, when there is no idle capacity every defective unit that must be reworked or that is scrapped uses precious capacity The resulting opportunity costs can be quite large

H The Trade-Off Between Prevention and Appraisal Costs and Internal and External Failure Costs. Generally speaking, companies should focus more effort on prevention and appraisal And prevention is usually better than appraisal Most authorities agree that the costs of internal and external failures have been largely hidden and as a consequence managers are unaware of the magnitude of the problem Very simple steps can often be taken to prevent defects These simple steps pay enormous dividends in terms of reducing the need for appraisal and in reducing the incidence of internal and external failures

I Quality Cost Report Quality consultants claim that top managers often do not pay enough attention to quality since the costs of low quality (i.e., high defect rates) are hidden by the typical cost accounting system While accounting systems often report statistics concerning

scrap and there may be a quality assurance department with its own budget, many of the other costs associated with defects are buried in general overhead or in other accounts A quality cost report makes these costs visible and organizes the data so as to help managers make trade-offs Since the reports are really just attention-directing devices, the numbers in the reports do not have to be precise

1 Data for the Quality Cost Report The costs of nonconformance (i.e., defects) often cut

across departmental lines and are therefore somewhat difficult to collect Moreover, some

of the costs of nonconformance are entirely external to the company and are not captured

by the accounting system at all The most prominent example of this is the cost of lost sales Nevertheless, as we indicated above, precision is not terribly important so these measurement and identification problems should not be overemphasized All of the examples and problems in the text assume that the data collection work has already been done

2 Format and use of the Quality Cost Report It is very helpful to sort the various quality

costs into the four categories of prevention, appraisal, internal failure, and external failure costs By comparing the amounts in the various categories, managers can get some feel for what should be done For example, if the prevention and appraisal costs are very small relative to the internal and external failure costs, it is likely that not enough is being spent

to prevent and detect defects If prevention costs are low relative to appraisal costs, it is likely that not enough is being spent on prevention relative to inspection Moreover, by comparing results across years, managers can track the effects of their decisions and gauge the success of quality improvement programs

3 The future of the Quality Cost Report A company’s first quality cost report probably has

the greatest effect Managers are often surprised by the magnitude of the costs associated with defects This is often enough by itself to propel the company into ambitious quality improvement programs However, unless the company’s chart of accounts is modified, compiling periodic quality cost reports is a time-consuming task Moreover, some of the most important data—the data external to the company—will almost always be missing And, while the quality cost report can help steer managers in the appropriate direction (e.g., increase prevention costs), it cannot tell managers how to go about preventing defects For these reasons, many companies stop producing quality cost reports once their quality improvement program is well-established

Assignment Materials

Assignment Topic

Level of Difficulty

Suggested Time

Exercise 2-1 Classifying manufacturing costs Basic 15 min Exercise 2-2 Classification of costs as period or product cost Basic 15 min Exercise 2-3 Constructing an income statement Basic 15 min Exercise 2-4 Prepare a schedule of cost of goods manufactured Basic 15 min Exercise 2-5 Classification of costs as fixed or variable Basic 15 min Exercise 2-6 Identifying direct and indirect costs Basic 15 min Exercise 2-7 Differential, opportunity, and sunk costs Basic 15 min Exercise 2-8 (Appendix 2A) Classification of overtime cost Basic 15 min Exercise 2-9 (Appendix 2B) Classification of quality costs Basic 15 min Exercise 2-10 Preparation of a schedule of COGM and COGS Basic 30 min Exercise 2-11 Classification of costs as fixed or variable and as selling and

administrative or product Basic 15 min Exercise 2-12 Product cost flows; product versus period costs Basic 30 min Exercise 2-13 (Appendix 2A) Classification of labor costs Basic 15 min Problem 2-14 Cost identification Basic 30 min Problem 2-15 Cost classification Basic 30 min Problem 2-16 Cost classification Basic 30 min Problem 2-17 (Appendix 2A) Allocating labor costs Basic 30 min Problem 2-18 (Appendix 2B) Quality cost report Medium 60 min Problem 2-19 Classification of various costs Medium 30 min Problem 2-20 Classification of salary cost as a period or product cost Medium 15 min Problem 2-21 Variable and fixed costs; subtleties of direct and indirect costs Medium 15 min Problem 2-22 (Appendix 2B) Analyzing a quality cost report Medium 45 min Problem 2-23 Ethics and the manager Medium 30 min Problem 2-24 Schedule of cost of goods manufactured; cost behavior Medium 60 min Problem 2-25 Cost classification and cost behavior Medium 45 min Problem 2-26 Schedule of cost of goods manufactured; income statement Medium 60 min Problem 2-27 Schedule of cost of goods manufactured; income statement; cost

behavior Medium 60 min Problem 2-28 Income statement; schedule of cost of goods manufactured Difficult 60 min Problem 2-29 Working with incomplete data from the income statement and

schedule of cost of goods manufactured Difficult 45 min Case 2-30 Inventory computations from incomplete data Difficult 60 min Case 2-31 Missing data; income statement; schedule of cost of goods

manufactured Difficult 60 min Essential Problems:* Problem 2-14 or 2-19, Problem 2-15 or 2-16, Problem 2-24 or 2-27,

Problem 2-25

Supplementary Problems:* Problem 2-20, Problem 2-21, Problem 2-23, Problem 2-26, Problem

2-28, Problem 2-29, Case 2-30, Case 2-31

Appendix 2A Essential Problems: Problem 2-17

Appendix 2B Essential Problems: Problem 2-18

Appendix 2B Supplementary Problems: Problem 2-22

*See the front of the Solutions Manual for an explanation of “Essential” and “Supplementary”

problems

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Chapter 2 Lecture Notes

Helpful Hint: Before beginning the lecture, show students the second segment from the first tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library This segment introduces students to many of the concepts discussed in chapter 2 The lecture notes reinforce the concepts introduced in the video

Chapter theme: Managers need to rely upon different

classifications of costs for different purposes The four main purposes emphasized in this chapter include

preparing external financial reports, predicting cost behavior, assigning costs to cost objects, and making business decisions

I General cost classifications: Our initial focus is on

manufacturing companies since their basic activities

include most of the activities found in other types of

business organizations Nonetheless, many of the

concepts developed in this chapter apply to diverse

organizations

A Classifications of manufacturing costs (e.g., direct

materials, direct labor, and manufacturing overhead):

i Direct materials − Raw materials that

become an integral part of the finished product and that can be physically and conveniently traced to it

ii Direct labor − Labor costs that can be easily

traced to individual units of product (also called touch labor)

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iii Manufacturing overhead − Includes all

manufacturing costs except direct materials and direct labor These costs cannot be easily traced to specific units produced (also called indirect manufacturing cost, factory overhead, and factory burden)

1 Includes indirect materials that are part of

the finished product, but that cannot be easily traced to it

2 Includes indirect labor costs that cannot be

physically or conveniently traced to the creation of products

3 Other examples of manufacturing overhead include: maintenance and repairs on

production equipment, heat and light, property taxes, depreciation and insurance

on manufacturing facilities, etc

Helpful Hint: Use something in the classroom such as a chair to illustrate manufacturing cost concepts Center discussion on the raw materials classified as direct materials and as manufacturing overhead; labor costs classified as direct labor and as manufacturing

overhead; and other costs incurred to produce the chair that are classified as manufacturing overhead

iv Prime cost − Direct materials plus direct

7

“In Business Insights”

The amount of manufacturing costs for a manufacturing company is often quite high when stated as a

percentage of sales For example:

“Dissecting the Value Chain” (page 39)

• The apparel company United Colors of Benetton

reports that cost of sales is 56.4% of sales

• Even though the company spends large sums on

advertising, the cost of sales is still quite high in relation to net sales

B Classifications of nonmanufacturing costs (also

called selling, general and administrative, or S, G & A costs)

i Marketing or selling costs – Includes all

costs necessary to secure customer orders and get the finished product into the hands of the customer

ii Administrative costs – Includes all

executive, organizational, and clerical costs associated with the general management of an organization

“In Business Insights”

The amount of selling, general, and administrative expenses are significant for most organizations For example:

“Bloated Sales and Administrative Expenses” (page 40)

• The Boston Consulting Group found that S, G & A

expenses at America’s 1,000 largest companies

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grew at an average rate of 1.7% per year between

1985 and 1996 and then exploded to an average

of 10% growth per year between 1997 and 2000

• If companies had maintained their historical

balance between sales revenue and S, G & A expenses from 1997-2000, the S, G & A expenses would have been $500 million lower in the year

2000 for the average company on the list

• These findings suggest that S, G & A expenses

tend to creep up at a faster rate during economic booms, thus creating problems when the economy falls into recession

“Why Is Tuition So High?” (page 38)

• Forbes magazine reports that administrative

costs are very high for colleges and universities

• More specifically, an average of 2.5

administrators are employed for each faculty member in public colleges and 1.9 in private colleges

C Product costs versus period costs

i Product costs (also called inventoriable

costs) – Includes all the costs that are

involved in acquiring or making a product More specifically, it includes direct materials, direct labor, and manufacturing overhead

1 Consistent with the matching principle, product costs are recognized as expenses when the products are sold

ii Period costs – Includes all marketing or

selling costs and administrative costs

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1 These costs are expensed on the income statement in the period incurred

Quick Check − product versus period costs

II Cost classifications on financial statements

A Merchandising vs manufacturing companies

i Merchandising companies − Purchase

finished goods from suppliers for resale to customers

ii Manufacturing companies − Purchase raw

materials from suppliers and produce and sell finished goods to customers

B The balance sheet: merchandising vs

manufacturing companies

i Merchandising companies do not have to

distinguish between raw materials, work in process, and finished goods They report one inventory number on their balance sheet

labeled merchandise inventory

ii Manufacturing companies report three types

of inventory on their balance sheets

1 Raw materials – The materials used to

make the product

2 Work in process – Consists of units of

product that are partially complete, but will

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require further work to be saleable to customers

3 Finished goods – Consists of units of

product that have been completed but not yet sold to customers

C The income statement: merchandising vs

manufacturing companies

i Merchandising companies calculate cost of

goods sold as:

COGS = BMI + Purchases – EMI

ii Manufacturing companies calculate cost of

goods sold as:

COGS = BFGI + COGM – EFGI

Helpful Hint: Before proceeding, enhance students’

understanding by explaining that the raw materials, work

in process, and finished goods inventories all follow the same logic They start out with some beginning inventory Additions are made during the period At the end of the period, everything that started in the inventory or that was added must either be in the ending inventory or have been transferred out to another inventory account or to cost of goods sold

Quick Check − inventory flows

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D The schedule of cost of goods manufactured

i This schedule contains the three elements of

costs mentioned previously, namely direct

materials, direct labor, and manufacturing overhead

ii It calculates the cost of raw material, direct

labor and manufacturing overhead used in production

iii It calculates the manufacturing costs

associated with goods that were finished during the period

E Product cost flows

i To create a schedule of cost of goods

manufactured as well as a balance sheet and income statement, it is important to

understand the flow of product costs:

1 Raw material purchases made during the period are added to beginning raw materials inventory The ending raw materials

inventory is deducted to arrive at the raw

materials used in production

a As items are removed from raw materials inventory and placed into the production process, they are called direct materials

2 Direct labor and manufacturing overhead (also called conversion costs) used in production are added to direct materials to

arrive at total manufacturing costs

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3 Total manufacturing costs are added to the

beginning work in process to arrive at total

deducted from this figure to arrive at cost of

goods sold

6 All raw materials, work in process, and unsold finished goods at the end of the period are shown as inventoriable costs in

the asset section of the balance sheet

7 As finished goods are sold, their costs are transferred to cost of goods sold on the

income statement

8 Selling and administrative expenses are not involved in making the product; therefore,

they are treated as period costs and reported

in the income statement for the period the cost is incurred

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Quick Check − product cost flows

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III Cost classifications for predicting cost behavior

A Cost behavior refers to how a cost will react to changes in the level of activity within the relevant

range The most commonly used classifications of

cost behavior are variable and fixed costs:

i Variable cost − A cost that varies, in total, in

direct proportion to changes in the level of activity However, variable cost per unit is constant

ii Fixed cost − A cost that remains constant, in

total, regardless of changes in the level of the activity However, if expressed on a per unit basis, the average fixed cost per unit varies inversely with changes in activity

iii It is helpful to think about variable and fixed

cost behavior in a 2x2 matrix

Helpful Hint: To illustrate fixed costs, ask students for the cost of a large pizza Then ask: What would be the cost per student if two students buy a pizza? What if four students buy a pizza? This makes it clear why average fixed costs change on a per unit basis To illustrate variable costs, add that a beverage costs $1 and each student eating the pizza has one beverage

So, if two people were eating the pizza, the total beverage bill would come to $2; if four people, $4 The cost per beverage remains the same, but the total cost depends on the number of people ordering a beverage Quick Check – variable vs fixed costs

41

“In Business Insights”

Variable costs in some industries can be very low relative to fixed costs For example:

“The Cost of a Call” (page 50)

• Costs in the telecommunications industry are

almost all fixed

• The cost of physically transporting a call is only

about 7% of what customers pay for the call

• It costs a telephone company more to bill a

customer for a phone call than it costs the phone company to actually make the call

IV Cost classifications for assigning costs to cost objects

A Cost object − Anything for which cost data are desired

including products, customers, jobs, organizational subunits, etc For purposes of assigning costs to cost objects costs are classified two ways:

i Direct costs − Costs that can be easily and

conveniently traced to a unit of product or other cost object

ii Indirect costs − Costs that cannot be easily

and conveniently traced to a unit of product or other cost object

1 Common costs − Indirect costs incurred to

support a number of cost objects These costs cannot be traced to any individual cost object

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V Cost classifications for decision making

A It is important to realize that every decision involves a choice between at least two alternatives The goal of making decisions is to identify those costs that are

either relevant or irrelevant to the decision To make

decisions, it is essential to have a grasp on three concepts:

i Differential costs (or incremental costs) − A

difference in cost between any two alternatives (a difference in revenue between

two alternatives is called differential

revenue)

1 Differential costs can be either fixed or variable

“In Business Insights”

Incremental costs can be negligible for some companies

in certain situations For example:

“Using Those Empty Seats” (page 52)

• The Corporate Angel Network arranges free

flights on some 1,500 corporate jets from over

500 companies for cancer patients who need specialized treatment outside their home areas

• Corporate jets typically fly with only one or two

executives on board The incremental cost of occupying an empty seat is negligible

• Since its founding, the Corporate Angel Network

has leveraged the incremental cost concept by arranging over 14,000 free flights for cancer patients

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ii Opportunity cost − The potential benefit that

is given up when one alternative is selected over another

1 These costs are not usually entered into the accounting records of an organization, but must be explicitly considered in all

decisions

Helpful Hint: Ask students what opportunity costs they incur by attending class Their opportunity cost is the value to them of the activity they would be doing otherwise (e.g., working, sleeping, partying, studying, etc.)

iii Sunk cost − A cost that has already been

incurred and that cannot be changed now or in the future

Helpful Hint: Ask students: “Suppose you had purchased gold for $400 an ounce, but now it is selling for $250 an ounce Should you wait for the gold to reach $400 an ounce before selling it?” Many students will say “yes” even though the $400 purchase is a sunk cost

Quick Check − relevant costs

VI Summary of the types of cost classifications

A We have looked at the cost classifications used for

financial reporting, predicting cost behavior, assigning costs to cost objects, and making business decisions

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46-51

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VII Appendix 2A: further classification of labor costs

A Accounting for idle time, overtime, and fringe benefits

i Idle time − Machine breakdowns, material

shortages, power failures and the like result in idle time The labor costs incurred during idle time are ordinarily treated as

manufacturing overhead This enables the costs to be spread across all the production rather than the units in process when the disruptions occur

ii Overtime − The overtime premiums for all

factory workers are usually considered to be part of manufacturing overhead This is done

to avoid penalizing particular products or customer orders simply because they happen

to fall on the tail end of the daily production schedule

iii Labor fringe benefits − These costs relate to

employment-related costs paid by an employer such as insurance programs, retirement plans, and supplemental unemployment programs They also include the employer’s share of Social Security, Medicare, workers’ compensation, federal employment tax, and state unemployment insurance

1 These costs often add up to 30% to 40% of

an employee’s base pay

2 Some companies include all of these costs in manufacturing overhead Other companies

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