Chapter 02 – Lecture Notes
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Chapter 2
Lecture Notes
Chapter theme: This chapter explains how managers
need to rely on different cost classifications for different
purposes. The four main purposes emphasized in this
chapter include assigning costs to cost objects,
preparing external financial reports, predicting cost
behavior, and decision making.
I. Summary of the types of cost classifications
A. This slide summarizes the types of cost classifications
that will be discussed in this chapter, namely cost
classifications for assigning costs to cost objects,
financial reporting, predicting cost behavior, and
making business decisions.
II. Cost classifications for assigning costs to cost objects
Learning Objective 1: Understand cost classifications
used for assigning costs to cost objects: direct costs and
indirect costs.
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 specified cost object.
ii. Indirect costs − Costs that cannot be easily
and conveniently traced to a specified cost
object.
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1. Common costs − Indirect costs incurred to
support a number of cost objects. These
costs cannot be traced to any individual cost
object.
III. Cost classifications for manufacturing companies
Manufacturing companies separate their costs into two
broad categories—manufacturing and nonmanufacturing
costs.
Learning Objective 2: Identify and give examples of
each of the three basic manufacturing cost categories.
A. Classifications of manufacturing costs
i. Direct materials − Raw materials that
become an integral part of the finished
product and whose costs can be conveniently
traced to it.
ii. Direct labor − Labor costs that can be easily
traced to individual units of product (also
called touch labor).
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.
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2. Includes indirect labor costs that cannot be
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.
B. Classifications of nonmanufacturing costs (also called
selling and administrative costs).
i. Selling costs – Includes all costs necessary to
secure customer orders and get the finished
product into the hands of the customer.
Selling costs can be either direct or indirect
costs.
ii. Administrative costs – Includes all costs
associated with the general management of an
organization. Administrative costs can be
either direct or indirect costs.
Learning Objective 3: Understand cost classifications
used to prepare financial statements: product costs and
period costs.
C. Cost classifications for preparing financial
statements
i. Product 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.
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1. Product costs are expensed in the income
statement when the products are sold.
ii. Period costs – Includes all selling and
administrative costs.
1. These costs are expensed in the income
statement in the period incurred.
Quick Check
−
product versus period costs
D. Prime costs and conversion costs
i. Prime cost − Direct materials cost plus direct
labor cost.
ii. Conversion cost – Direct labor cost plus
manufacturing overhead costs.
IV. Cost classifications for predicting cost behavior
Learning Objective 4: Understand cost classifications
used to predict cost behavior: variable costs, fixed
costs, and mixed costs.
A. Cost behavior refers to how a cost will react to changes
in the level of activity. The most commonly used
classifications of cost behavior are variable, fixed, and
mixed 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.
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1. An activity base (also called a cost driver)
is a measure of what causes the incurrence
of variable costs. As the level of the activity
base increases, the total variable cost
increases proportionally.
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.
1. Committed fixed costs represent
investments with a multi-year planning
horizon that cannot be easily adjusted in the
short term.
2. Discretionary fixed costs usually arise from
annual decisions by management and they
can be easily reduced in the short term.
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.
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iii. The linearity assumption and the relevant
range − Accountants usually assume that
costs are strictly linear; however, economists
point out that many costs are actually
curvilinear. Nonetheless, within a narrow
band of activity known as the relevant range,
a curvilinear cost can be satisfactorily
approximated by a straight line.
1. The relevant range is that range of activity
within which the assumptions made about
cost behavior are valid.
iv. The relevant range of activity pertains to
fixed cost as well as variable costs.
1. For example, assume office space is
available at a rental rate of $30,000 per year
in increments of 1,000 square feet.
2. Fixed costs would increase in a step fashion
at a rate of $30,000 for each additional 1,000
square feet.
v. The relevant range for a fixed cost is the
range of activity over which the graph of the
cost is flat.
vi. It is helpful to think about variable and fixed
cost behavior in a 2×2 matrix.
Quick Check – variable vs. fixed costs
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vii. Mixed cost – A cost that contains both
variable and fixed elements.
1. For example, utility bills often contain fixed
and variable cost components.
a. The fixed portion of the utility bill is
constant regardless of kilowatt hours
consumed. This cost represents the
minimum cost that is incurred to have
the service ready and available for
use.
b. The variable portion of the bill varies
in direct proportion to the
consumption of kilowatt hours.
ii. An equation can be used to express the relationship
between mixed costs and the level of the activity.
This equation can be used to calculate what the
total mixed cost would be for any level of activity.
1. The equation is Y = a + bX
a. Y = The total mixed cost.
b. a = The total fixed cost (the vertical
intercept of the line).
c. b = The variable cost per unit of
activity (the slope of the line).
d. X = The level of activity.
iii. For example, if your fixed monthly utility charge is
$40, your variable cost is $0.03 per kilowatt hour,
and your monthly activity level was 2,000 kilowatt
hours, this equation can be used to calculate your
total utility cost of $100.
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