Lecture 2

1. Introduction to Cost Concepts

1.1 Purpose of Cost Classification

  • Assign costs to cost objects.

  • Account for costs in manufacturing.

  • Prepare financial statements.

  • Predict cost behavior in response to changes in activity.

  • Estimate the cost function.

  • Make informed decisions.

2. Cost Classifications

2.1 Direct Costs vs. Indirect Costs

2.1.1 Direct Costs

  • Costs easily traced to a product or cost object.

  • Examples: Direct materials (raw materials) and direct labor (wages).

2.1.2 Indirect Costs

  • Costs that cannot be easily traced to a product.

  • Examples: Manufacturing overhead (indirect materials, indirect labor).

    • Common Costs: Indirect costs that support multiple cost objects but cannot be traced to any individual cost object.

2.2 Manufacturing Cost Categories

  • Direct Manufacturing Costs:

    • Direct Materials: Integral raw materials traced to products (e.g., seat in an aircraft).

    • Direct Labor: Labor costs that can be traced (e.g., wages of assembly workers).

  • Manufacturing Overhead: All manufacturing costs excluding direct materials and direct labor (e.g., depreciation, utilities).

2.3 Non-Manufacturing Costs

  • Selling Costs: Expenses to secure orders and deliver products (can be direct or indirect).

  • Administrative Costs: Executive and clerical costs (can be direct or indirect).

3. Financial Statement Preparation

3.1 Product Costs vs. Period Costs

3.1.1 Product Costs

  • Include all costs involved in acquiring or making a product:

    • Raw materials, work in progress, finished goods.

  • Costs remain attached as inventory until sold.

3.1.2 Period Costs

  • Selling and administrative expenses not attached to product cost.

3.2 Understanding the Transfer of Product Costs

  • As production occurs, costs move from Raw Materials to Work in Process, then to Finished Goods, and finally to Cost of Goods Sold when sold.

4. Cost Behavior Analysis

4.1 Types of Costs

  • Variable Costs: Costs that change with activity level (e.g., utility cost based on kilowatt-hours).

  • Fixed Costs: Remain constant as activity changes (e.g., monthly telephone bill).

  • Mixed Costs: Contain both variable and fixed components (e.g., utility bills with a fixed charge plus variable charge).

4.2 Relevant Range

  • The range of activity over which cost behavior patterns are consistent.

  • Fixed costs may increase in a step-wise fashion outside the relevant range.

4.3 Types of Fixed Costs

  • Discretionary Costs: Can be altered in the short term.

  • Committed Costs: Long-term costs that cannot be easily reduced.

5. Decision-Making Costs

5.1 Relevant vs. Irrelevant Costs

  • Relevant Costs: Costs that directly affect decision-making.

  • Irrelevant Costs: Sunk costs that should be ignored.

5.2 Types of Relevant Costs

  • Differential Costs: Differences in costs between alternatives.

  • Opportunity Costs: Benefits forfeited when selecting one alternative over another.

6. Income Statement Formats

6.1 Contribution Format

  • Focuses on cost behavior:

    • Contribution Margin covers fixed costs and indicates profit.

6.2 Traditional Format vs. Contribution Format

  • Traditional focuses on gross margin for external reporting, while contribution is used for internal decision-making and planning.

7. Conclusion

  • Understanding cost concepts is vital for accounting and management to prepare accurate financial statements, analyze costs, and make informed decisions.