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CHAPTER 2
AN INTRODUCTION TO COST TERMS AND PURPOSES
2-1 Define cost object and give three examples.
2-2 Define direct costs and indirect costs.
Direct costs of a cost object are related to the particular cost object and can be traced to that cost
2-3 Why do managers consider direct costs to be more accurate than indirect costs?
2-4 Name three factors that will affect the classification of a cost as direct or indirect.
Factors affecting the classification of a cost as direct or indirect include
2-5 Define variable cost and fixed cost. Give an example of each.
A variable cost changes in total in proportion to changes in the related level of total activity or
A fixed cost remains unchanged in total for a given time period, despite wide changes in
2-6 What is a cost driver? Give one example.
A cost driver is a variable, such as the level of activity or volume that causally affects total costs
2-7 What is the relevant range? What role does the relevant-range concept play in explaining
2-1
how costs behave?
2-8 Explain why unit costs must often be interpreted with caution.
A unit cost is computed by dividing some amount of total costs (the numerator) by the related
2-9 Describe how manufacturing-, merchandising-, and service-sector companies differ from
one another.
Manufacturing-sector companies purchase materials and components and convert them into
2-10 What are three different types of inventory that manufacturing companies hold?
Manufacturing companies have one or more of the following three types of inventory:
1. Direct materials inventory. Direct materials in stock and awaiting use in the
2-11 Distinguish between inventoriable costs and period costs.
Inventoriable costs are all costs of a product that are considered as assets in the balance sheet
Period costs are all costs in the income statement other than cost of goods sold. These
2-12 Define the following: direct material costs, direct manufacturing-labor costs,
manufacturing overhead costs, prime costs, and conversion costs.
2-2
Direct material costs are the acquisition costs of all materials that eventually become part of the
Manufacturing overhead costs are all manufacturing costs that are related to the cost
Prime costs are all direct manufacturing costs (direct material costs and direct
2-13 Describe the overtime-premium and idle-time categories of indirect labor.
Overtime premium is the wage rate paid to workers (for both direct labor and indirect labor) in
Idle time is a subclassification of indirect labor that represents wages paid for
2-14 Define product cost. Describe three different purposes for computing product costs.
A product cost is the sum of the costs assigned to a product for a specific purpose. Purposes for
computing a product cost include
2-15 What are three common features of cost accounting and cost management?
Three common features of cost accounting and cost management are
2-16 Applewhite Corporation, a manufacturing company, is analyzing its cost structure in a
project to achieve some cost savings. Which of the following statements is/are correct?
I. The cost of the direct materials in Applewhite’s products is considered a variable cost.
2-3
1. I, II, and III are correct.
2. I only is correct.
3. II and III only are correct.
4. None of the listed choices is correct.
SOLUTION
Choice "2" is correct.This question asks which of a series of statements about costs is/are correct.
"All of the above" is an available option.Statement I says that the cost of the direct materials in
Applewhite's products is considered a variable cost. The more Applewhite manufactures, the
more the total cost of the direct materials will be. Statement I is correct.Statement II says that the
cost of depreciation of Applewhite's plant machinery is considered a variable cost because
Applewhite uses an accelerated depreciation method for both book and income tax purposes. Just
because a cost changes over time (which is what using an accelerated depreciation method will
cause) does not mean that the cost is variable. The fact that Applewhite may use the same
method for book and tax purposes is irrelevant. Statement II is wrong.Statement III says that the
cost of electricity for Applewhite's manufacturing facility is considered a fixed cost, even if the
cost of the electricity has both variable and fixed components. The cost of the electricity would
be considered a "mixed" cost, not a fixed cost. Statement III is wrong.
2-17 Comprehensive Care Nursing Home is required by statute and regulation to maintain a
minimum 3 to 1 ratio of direct service staff to residents to maintain the licensure associated with
the Nursing Home beds. The salary expense associated with direct service staff for the
Comprehensive Care Nursing Home would most likely be classified as:
1. Variable cost.
SOLUTION
Choice "2" is correct.Costs that maintain production capacity and do not vary regardless of
utilization are classified as fixed costs. In this instance, the salary costs of direct service staff are
required to maintain capacity based on the number of residents (doctors) and will be incurred
whether the facility is full or empty. The costs are fixed.Choice "1" is incorrect. Direct labor
costs mandated by statute do not vary with production, they vary with the compliance
requirement. Consequently direct labor costs, in this instance, are fixed, not variable.Choice "3"
is incorrect. Direct costs related to service provider salaries are considered to be direct costs of
the service, not overhead costs.Choice "4" is incorrect. Comprehensive Care Nursing Home is a
service company and does not have any inventory and therefore no inventoriable costs.
2-18 Frisco Corporation is analyzing its fixed and variable costs within its current relevant
range. As its cost driver activity changes within the relevant range, which of the following
statements is/are correct?
I. As the cost driver level increases, total fixed cost remains unchanged.
II. As the cost driver level increases, unit fixed cost increases.
III. As the cost driver level decreases, unit variable cost decreases.
2-4
4. II and III only are correct.
SOLUTION
Choice "3" is correct.The question asks what happens to variable and fixed costs when cost
driver activity changes (i.e., when the cost driver level increases or decreases). Statement I says
that, as the cost driver level increases, total fixed cost remains unchanged. Statement I is correct.
Total fixed cost will remain unchanged regardless of changes in the cost driver because total
fixed cost is unaffected by changes in the cost driver.Statement II says that, as the cost driver
level increases, unit fixed cost increases. This statement is asking about unit fixed cost like the
previous statement asked about total fixed cost. While total fixed cost will remain unchanged
regardless of changes in the cost driver, unit fixed cost will not. If the cost driver level increases,
total fixed cost will remain the same, but the total number of units will increase, and unit fixed
cost will decrease, not increase. Statement II is incorrect. Statement III says that as the cost
driver level decreases, unit variable cost decreases. This statement is asking about unit variable
cost like the previous statement asked about unit fixed cost. Unit variable cost will remain
unchanged regardless of what happens to the cost driver. Statement III is incorrect.
2-19 Year 1 financial data for the ABC Company is as follows:
Sales $5,000,000
Direct materials 850,000
Direct manufacturing labor 1,700,000
Variable manufacturing overhead 400,000
Fixed manufacturing overhead 750,000
Variable SG&A 150,000
Fixed SG&A 250,000
Under the absorption method, Year 1 Cost of Goods sold will be:
a. $2,550,000 c. $3,100,000
b. $2,950,000 d. $3,700,000
SOLUTION
Choice "d" is correct. Under the absorption method, Cost of Goods Sold is calculated by adding
direct materials, direct manufacturing labor, variable manufacturing overhead, and fixed
manufacturing overhead. Therefore, Cost of Goods Sold = $850,000 + $1,700,000 + $400,000 +
$750,000 = $3,700,000.Choice "a" is incorrect. This calculation only takes into account direct
materials and direct manufacturing labor.
Choice "b" is incorrect. This calculation incorrectly excludes fixed manufacturing overhead.
2-5
Choice "c" is incorrect. This calculation includes variable SG&A, but excludes fixed
manufacturing overhead.
2-20 The following information was extracted from the accounting records of Roosevelt
Manufacturing Company:
Direct materials purchased 80,000
Direct materials used 76,000
Direct manufacturing labor costs 10,000
Indirect manufacturing labor costs 12,000
Sales salaries 14,000
Other plant expenses 22,000
Selling and administrative expenses 20,000
What was the cost of goods manufactured?
1. $124,000 3. $154,000
2. $120,000 4. $170,000
SOLUTION
Explanation Choice "2" is correct.In this question, the problem is to calculate the cost of goods
manufactured. Certain cost data are provided. The problem assumes beginning and ending work in
process is zero. The cost of goods manufactured is calculated as indicated below:
Direct materials used $ 76,000
2-21 Computing and interpreting manufacturing unit costs. Minnesota Office Products
(MOP) produces three different paper products at its Vaasa lumber plant: Supreme, Deluxe, and
Regular. Each product has its own dedicated production line at the plant. It currently uses the
following three-part classification for its manufacturing costs: direct materials, direct
manufacturing labor, and manufacturing overhead costs. Total manufacturing overhead costs of
the plant in July 2017 are $150 million ($15 million of which are fixed). This total amount is
allocated to each product line on the basis of the direct manufacturing labor costs of each line.
Summary data (in millions) for July 2017 are as follows:
Supreme Deluxe Regular
Direct material costs $ 89 $ 57 $ 60
2-6
Supreme Deluxe Regular
Units produced 125 150 140
Required:
1. Compute the manufacturing cost per unit for each product produced in July 2017.
2. Suppose that, in August 2017, production was 150 million units of Supreme, 190 million
units of Deluxe, and 220 million units of Regular. Why might the July 2017 information on
manufacturing cost per unit be misleading when predicting total manufacturing costs in
August 2017?
SOLUTION
(15 min.) Computing and interpreting manufacturing unit costs.
1.
(in millions)
Supreme Deluxe Regular Total
Direct material cost $ 89.00 $ 57.00 $60.00 $206.00
Direct manuf. labor costs 16.00 26.00 8.00 50.00
Manufacturing overhead costs 48.00 78.00 24.00 150.00
Fixed costs allocated at a rate
of $15M
¸
$50M (direct mfg.
labor) equal to $0.30 per
dir. manuf. labor dollar
(0.30
´
$16; 26; 8) 4.80 7.80 2.40 15.00
Manuf. cost per unit (Total manuf.
Variable manuf. cost per unit
(Variable manuf. costs
(in millions)
Supreme Deluxe Regular Total
2. Based on total manuf. cost
per unit ($1.2240
´
150;
$1.0733
´
190; $0.6571
´
220) $183.60 $203.93 $144.56 $532.09
Correct total manuf. costs based
on variable manuf. costs plus
fixed costs equal
Variable costs ($1.1856
´
150; $177.84 $194.05 $140.80 $512.69
$1.0213
´
190; $0.64
´
220)
Fixed costs 15.00
Total costs $527.69
The total manufacturing cost per unit in requirement 1 includes $15 million of indirect
manufacturing costs that are fixed irrespective of changes in the volume of output per month,
2-7
while the remaining variable indirect manufacturing costs change with the production volume.
Given the unit volume changes for August 2017, the use of total manufacturing cost per unit
from the past month at a different unit volume level (both in aggregate and at the individual
product level) will overestimate total costs of $532.09 million in August 2017 relative to the
correct total manufacturing costs of $527.69 million calculated using variable manufacturing cost
per unit times units produced plus the fixed costs of $15 million.
2-22 Direct, indirect, fixed, and variable costs. California Tires manufactures two types of
tires that it sells as wholesale products to various specialty retail auto supply stores. Each tire
requires a three-step process. The first step is mixing. The mixing department combines some of
the necessary direct materials to create the material mix that will become part of the tire. The
second step includes the forming of each tire where the materials are layered to form the tire.
This is an entirely automated process. The final step is finishing, which is an entirely manual
process. The finishing department includes curing and quality control.
Required:
1. Costs involved in the process are listed next. For each cost, indicate whether it is a direct
variable, direct fixed, indirect variable, or indirect fixed cost, assuming “units of production of
each kind of tire” is the cost object.
Costs:
Rubber Mixing department manager
Reinforcement cables Material handlers in each department
Other direct materials Custodian in factory
Finishing department hourly laborers Machinist (running the forming machines)
2. If the cost object were the “mixing department” rather than units of production of each kind of
tire, which preceding costs would now be direct instead of indirect costs?
SOLUTION
(15 min.) Direct, indirect, fixed, and variable costs.
1. Rubber—direct, variable
Reinforcement cables—direct, variable
Other direct materials—direct, variable
Depreciation on formers—indirect, fixed (unless “units of output” depreciation, which then
would be variable)
Depreciation on mixing machines—indirect, fixed (unless “units of output” depreciation,
which then would be variable)
Rent on factory building—indirect, fixed
Fire Insurance on factory building—indirect, fixed
Factory utilities—indirect, probably some variable and some fixed (e.g., electricity may be
variable but heating costs may be fixed)
2-8
Finishing department hourly laborers—direct, variable (or fixed if the laborers are under a
union contract)
Mixing department manager—indirect, fixed
Materials handlers—depends on how they are paid. If paid hourly and not under union
contract, then indirect, variable. If salaried or under union contract, then indirect, fixed
Custodian in factory—indirect, fixed
Night guard in factory—indirect, fixed
Machinist (running the mixing machine)—depends on how they are paid. If paid hourly and
not under union contract, then indirect, variable. If salaried or under union contract,
then indirect, fixed
Machine maintenance personnel—indirect, probably fixed, if salaried, but may be variable if
paid only for time worked and maintenance increases with increased production
Maintenance supplies—indirect, variable
Cleaning supplies—indirect, most likely fixed because the custodians probably do the same
amount of cleaning every night
Machinist (running the forming machine)—depends on how they are paid. If paid hourly and
not under union contract, then indirect, variable. If salaried or under union contract,
then indirect, fixed
2. If the cost object is Mixing Department, then anything directly associated with the Mixing
Department will be a direct cost. This will include:
Depreciation on mixing machines
Mixing Department manager
Materials handlers (of the Mixing Department)
Machinist (running the mixing machines)
Machine Maintenance personnel (of the Mixing Department)
Maintenance supplies (if separately identified for the Mixing Department)
Of course the rubber, reinforcement cables and other direct materials will also be a direct cost of
the Mixing Department, but it is already a direct cost of each kind of tire produced.
2-23 Classification of costs, service sector. Market Focus is a marketing research firm that
organizes focus groups for consumer-product companies. Each focus group has eight individuals
who are paid $60 per session to provide comments on new products. These focus groups meet in
hotels and are led by a trained, independent marketing specialist hired by Market Focus. Each
specialist is paid a fixed retainer to conduct a minimum number of sessions and a per session fee
of $2,200. A Market Focus staff member attends each session to ensure that all the logistical
aspects run smoothly.
Required:
Classify each cost item (A–H) as follows:
a. Direct or indirect (D or I) costs of each individual focus group.
b. Variable or fixed (V or F) costs of how the total costs of Market Focus change as the number
of focus groups conducted changes. (If in doubt, select on the basis of whether the total costs
will change substantially if there is a large change in the number of groups conducted.)
You will have two answers (D or I; V or F) for each of the following items:
2-9
Cost Item D or I V or F
A.Payment to individuals in each focus group to provide comments on new
products
B. Annual subscription of Market Focus to Consumer Reports magazine
C.Phone calls made by Market Focus staff member to confirm individuals
will attend a focus group session (Records of individual calls are not kept.)
D. Retainer paid to focus group leader to conduct 18 focus groups per year on
new medical products
E. Recruiting cost to hire marketing specialists
F. Lease payment by Market Focus for corporate office
G.Cost of tapes used to record comments made by individuals in a focus group
session (These tapes are sent to the company whose products are being
tested.)
H.Gasoline costs of Market Focus staff for company-owned vehicles (Staff
members submit monthly bills with no mileage breakdowns.)
I. Costs incurred to improve the design of focus groups to make them more
effective
SOLUTION
(15–20 min.) Classification of costs, service sector.
Cost object: Each individual focus group
Cost variability: With respect to the number of focus groups
There may be some debate over classifications of individual items, especially with regard
to cost variability.
Cost Item D or I V or F
A D V
B I F
C I Fa
D I F
E I V
F I F
G D V
H I Vb
I I F
aSome students will note that phone call costs are variable when each call has a separate charge.
It is a fixed cost if Market Focus has a flat monthly charge for a line, irrespective of the amount
of usage.
2-24 Classification of costs, merchandising sector. Band Box Entertainment (BBE) operates
a large store in Atlanta, Georgia. The store has both a movie (DVD) section and a music (CD)
section. BBE reports revenues for the movie section separately from the music section.
Required:
Classify each cost item (A–H) as follows:
2-10
a. Direct or indirect (D or I) costs of the total number of DVDs sold.
b. Variable or fixed (V or F) costs of how the total costs of the movie section change as the total
number of DVDs sold changes. (If in doubt, select on the basis of whether the total costs will
change substantially if there is a large change in the total number of DVDs sold.)
You will have two answers (D or I; V or F) for each of the following items:
Cost Item D or I V or F
A. Annual retainer paid to a video distributor
B. Cost of store manager’s salary
C. Costs of DVDs purchased for sale to customers
D. Subscription to DVD Trends magazine
E. Leasing of computer software used for financial budgeting at
the BBE store
F. Cost of popcorn provided free to all customers of the BBE
store
G. Cost of cleaning the store every night after closing
H. Freight-in costs of DVDs purchased by BBE
2-11
