publicly accessible website, in whole or in part.
Learning Objectives
1. Why are costs associated with a cost object?
necessary?
3. How are costs classified on the financial statements, and why are such classifications useful?
4. How does the conversion process occur in manufacturing and service companies?
COST TERMINOLOGY AND COST
BEHAVIORS
CHAPTER
2
Chapter 02: Cost Terminology and Cost Behaviors IM 2
Terminology
Actual cost system: A costing system that charges Work in Process Inventory with the actual direct
Appraisal costs: Costs incurred to find mistakes not eliminated through prevention
Cost allocation: The assignment of an indirect cost to one or more cost objects using some reasonable
allocation base or driver
Cost management system (CMS): A set of formal methods developed for planning and controlling an
Cost object: Anything for which management wants to collect or accumulate costs
Direct costs: Costs which are conveniently and economically traceable to a particular cost object
service
Finished goods: The costs of units of inventory that have been fully completed
basis
Chapter 02: Cost Terminology and Cost Behaviors IM 3
Normal cost system: A costing system that charges the Work in Process Inventory with the actual costs
Overhead: Any factory or production cost that is indirect to the product or service (that is, a production–
Period costs: Costs related to business functions other than production (such as selling and
Predetermined overhead rate: A charge per unit of activity used to allocate or apply overhead cost from
Predictor: An activity measure that, when changed, is accompanied by consistent, observable changes
in a cost item
Prime costs: The primary costs (direct material and direct labor) of producing a product or delivering a
service
Raw material: The materials used in the production process. From the standpoint of conversion, raw
Relevant range: The assumed range of activity that reflects the company’s normal operating range and
Service company: A firm engaged in a high or moderate degree of conversion using a significant
amount of labor
Step cost: A cost that increases (decreases) in distinct amounts because of increased (decreased)
Total cost to account for: The sum of the beginning WIP Inventory and the total current manufacturing
costs (DM, DL, OH)
Work in process: The costs of work started but not yet completed
Chapter 02: Cost Terminology and Cost Behaviors IM 4
Lecture Outline
LO.1 Why are costs associated with a cost object?
A. Introduction
1. This chapter provides the necessary terminology to understand and communicate cost and
cost accumulation in a production environment.
2. To effectively communicate information, accountants must clearly understand the differences
3. To be useful, the term cost must be defined more specifically before “the cost” of a product or
service can be determined and communicated to others.
b. Unexpired cost: The portion of an asset’s value that has not yet been consumed or
B. Cost Terminology
1. A cost management system is a set of formal methods developed for planning and controlling
3. Association with Cost Object
a. A cost object is anything (e.g., a product, a product line, a customer) for which management
wants to collect or accumulate costs.
the cost object.
c. Direct costs are costs that can be conveniently and economically traced to the cost object.
i. For example, the cost of steel used by Toyota to manufacture a Highlander SUV is a
d. Indirect costs are costs that cannot be economically traced to the cost object but instead
i. For example, the cost of glue used to manufacture a Highlander SUV is an indirect cost
e. Costs may be direct or indirect depending upon the cost object.
Chapter 02: Cost Terminology and Cost Behaviors IM 5
i. As above, the glue used used to manufacture a Highlander SUV is an indirect cost when
assumptions necessary?
C. Reaction to Changes in Activity
1. General
a. A cost’s behavior pattern is described according to the way its total cost (rather than its unit
b. Common activity measures include production volume, service and sales volumes, hours of
c. The relevant range is the assumed range of activity that reflects the company’s normal
operating range.
d. Accountants assume that there are three cost behavior patterns: variable, fixed, and mixed.
i. A variable cost is a cost that varies in total in direct proportion to changes in activity but
ii. A fixed cost is a cost that remains constant in total within the relevant range of activity
iii. A mixed cost has both a variable and a fixed component as illustrated in text Exhibit 2.4
i. For example, installing new automated production equipment would result in an
f. A step cost is a cost that shifts upward or downward when activity changes by a certain
Chapter 02: Cost Terminology and Cost Behaviors IM 6
i. If the company operates only within the relevant range of activity, the assumed
conditions approximate reality and, thus, the cost behaviors are appropriate.
ii. Second, selection of a constant per-unit variable cost and a constant total fixed cost
h. Selection of an appropriate activity measure is important.
i. A predictor is an activity measure that, when changed, is accompanied by consistent,
ii. A cost driver is a predictor that has an absolute cause–and-effect relationship with the
cost in question.
iii. Text Exhibit 2.5 (p. 29) illustrates the linear cause-and-effect relationship between
cost drivers to predict different costs.
LO.3 How are costs classified on the financial statements, and why are such classifications
useful?
2. Classification on the Financial Statements
a. The balance sheet is a statement of unexpired costs (assets) and liabilities and owners’
b. The matching concept provides a basis for deciding when an unexpired cost becomes an
c. When the product is specified as the cost object, all costs can be classified as either product
d. Product costs, also called inventoriable costs, are related to making or acquiring the
products or providing the services that directly generate the revenues of an entity.
ii. Direct labor refers to the time spent by individuals who work specifically on manufacturing
iii. Overhead is any factory or production cost that is indirect (i.e., not direct material or direct
Chapter 02: Cost Terminology and Cost Behaviors IM 7
publicly accessible website, in whole or in part.
f. The sum of direct material and direct labor cost is referred to as prime cost as those are the
g. Period costs are related to business functions other than production, such as selling and
administration.
ii. Period costs that have future benefit are classified as assets, whereas those having no
product or service.
LO.4 How does the conversion process occur in manufacturing and service companies?
D. The Conversion Process
1. General
b. Conversion process outputs are usually either products or services.
c. See text Exhibit 2.6 (p. 31) for a comparison of the conversion activities of different types of
organizations.
e. In high-conversion firms, the informational benefits gained from accumulating the material,
g. A service company refers to a for-profit business or not-for-profit organization that uses a
2. Retailers versus Manufacturers/Service Companies
publicly accessible website, in whole or in part.
c. A cost accounting system is required to assign the materials or supplies and conversion costs
i. Work not started (raw material);
ii. Work started but not completed (work in process); and
iii. Work completed (finished goods).
those of a manufacturing/service company.
i. As shown in the exhibit, unlike manufacturers and service firms, retail firms have no
conversion process.
i. In the first stage of processing, the costs incurred reflect the prices paid for raw materials
and/or supplies.
accumulated and attached to the goods.
iii. The total costs incurred in stages 1 and 2 equal the total production cost of finished
goods in stage 3.
3. Manufacturers versus Service Companies
i. When supplies are placed into process, labor and overhead are added to achieve
b. Manufacturers use three inventory accounts: (1) Raw Material Inventory (instead of