CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

CHAPTER 2

AN INTRODUCTION TO COST TERMS AND PURPOSES

2-1 A cost object is anything for which a separate measurement of costs is desired. Examples include a product, a service, a project, a customer, a brand category, an activity, and a department.

2-2 Direct costs of a cost object are related to the particular cost object and can be traced to that cost object in an economically feasible (cost-effective) way.

Indirect costs of a cost object are related to the particular cost object but cannot be traced to that cost object in an economically feasible (cost-effective) way.

Cost assignment is a general term that encompasses the assignment of both direct costs and indirect costs to a cost object. Direct costs are traced to a cost object while indirect costs are allocated to a cost object.

2-3 Managers believe that direct costs that are traced to a particular cost object are more accurately assigned to that cost object than are indirect allocated costs. When costs are allocated, managers are less certain whether the cost allocation base accurately measures the resources demanded by a cost object. Managers prefer to use more accurate costs in their decisions.

2-4 Factors affecting the classification of a cost as direct or indirect include

• the materiality of the cost in question,

• available information-gathering technology,

• design of operations

2-5 A variable cost changes in total in proportion to changes in the related level of total activity or volume. An example is a sales commission that is a percentage of each sales revenue dollar.

A fixed cost remains unchanged in total for a given time period, despite wide changes in the related level of total activity or volume. An example is the leasing cost of a machine that is unchanged for a given time period (such as a year) regardless of the number of units of product produced on the machine.

2-6 A cost driver is a variable, such as the level of activity or volume, that causally affects total costs over a given time span. A change in the cost driver results in a change in the level of total costs. For example, the number of vehicles assembled is a driver of the costs of steering wheels on a motor-vehicle assembly line.

2-7 The relevant range is the band of normal activity level or volume in which there is a specific relationship between the level of activity or volume and the cost in question. Costs are described as variable or fixed with respect to a particular relevant range.

2-8 A unit cost is computed by dividing some amount of total costs (the numerator) by the related number of units (the denominator). In many cases, the numerator will include a fixed cost that will not change despite changes in the denominator. It is erroneous in those cases to multiply the unit cost by activity or volume change to predict changes in total costs at different activity or volume levels.

2-9 Manufacturing-sector companies purchase materials and components and convert them into various finished goods, for example automotive and textile companies.

Merchandising-sector companies purchase and then sell tangible products without changing their basic form, for example retailing or distribution.

Service-sector companies provide services or intangible products to their customers, for example, legal advice or audits.

2-10 Manufacturing companies typically have one or more of the following three types of inventory:

1. Direct materials inventory. Direct materials in stock and awaiting use in the manufacturing process.

2. Work-in-process inventory. Goods partially worked on but not yet completed. Also called work in progress.

3. Finished goods inventory. Goods completed but not yet sold.

2-11 Inventoriable costs are all costs of a product that are considered as assets in the balance sheet when they are incurred and that become cost of goods sold when the product is sold. These costs are included in work-in-process and finished goods inventory (they are “inventoried”) to accumulate the costs of creating these assets.

Period costs are all costs in the income statement other than cost of goods sold. These costs are treated as expenses of the accounting period in which they are incurred because they are expected not to benefit future periods (because there is not sufficient evidence to conclude that such benefit exists). Expensing these costs immediately best matches expenses to revenues.

2-12 No. Service sector companies have no inventories and, hence, no inventoriable costs.

2-13 Direct material costs are the acquisition costs of all materials that eventually become part of the cost object (work in process and then finished goods), and can be traced to the cost object in an economically feasible way.

Direct manufacturing labor costs include the compensation of all manufacturing labor that can be traced to the cost object (work in process and then finished goods) in an economically feasible way.

Manufacturing overhead costs are all manufacturing costs that are related to the cost object (work in process and then finished goods), but cannot be traced to that cost object in an economically feasible way.

Prime costs are all direct manufacturing costs (direct material and direct manufacturing labor).

Conversion costs are all manufacturing costs other than direct material costs.

2-14 Overtime premium is the wage rate paid to workers (for both direct labor and indirect labor) in excess of their straight-time wage rates.

Idle time is a subclassification of indirect labor that represents wages paid for unproductive time caused by lack of orders, machine breakdowns, material shortages, poor scheduling, and the like.

2-15 A product cost is the sum of the costs assigned to a product for a specific purpose. Purposes for computing a product cost include

• pricing and product mix decisions,

• contracting with government agencies, and

• preparing financial statements for external reporting under generally accepted accounting

...