CHAPTER 2
BASIC COST MANAGEMENT CONCEPTS
Although this chapter is somewhat basic, it is very important because it introduces terminology that is
used throughout the text. Students will not be able to master topics covered in other chapters if they have
failed to master the basic cost concepts and definitions discussed in this chapter.
LEARNING OBJECTIVES
After studying Chapter 2, students should be able to:
2. Explain the cost assignment process.
4. Prepare income statements for manufacturing and service organizations.
5. Explain the differences between traditional and contemporary cost management systems.
KEY TOPICS
The following major topics are covered in this chapter (related learning objectives are listed for each
topic):
2. Cost Assignment: Direct Tracing, Driver Tracing, and Allocation (LO 2)
4. External Financial Statements (LO 4)
5. Traditional and Activity-Based Cost Management Systems (LO 5)
I. A SYSTEMS FRAMEWORK
A system is a set of interrelated parts that performs one or more processes to accomplish specific
objectives. An example of a system is the theater system for a home. Exhibit 2.1 (p. 26) illustrates the
operational model of a home-theater system. An accounting information system consists of: objectives,
interrelated parts, processes, and outputs. Inputs are generally economic events and the operational model
of an accounting system is critically involved with the user of information. Exhibit 2.2 (p. 28) presents an
operational model of an accounting information system.
There are two basic accounting information systems: the financial accounting information system and the
cost management information system. Each system is designed to satisfy different purposes. The financial
accounting information system is an accounting information subsystem that is primarily concerned with
producing outputs for external users. The cost management information system is an accounting
information subsystem that is primarily concerned with producing outputs for internal users using inputs
and processes needed to satisfy management objectives.
The cost management information system provides information for (1) costing services, products, and
other objects of interest to management, (2) planning and control, and (3) decision making. Because
managers in many different areas of a business require cost information, a high-quality cost management
system should have an organization-wide perspective and be able to interact with other information
systems within the organization.
Teaching hint: You may wish to discuss Exercise 2.9 at this time.
The value chain is the set of activities required to design, develop, produce, market, deliver, and provide
post-sales service for the products and services sold to customers. Emphasizing customer value forces
managers to determine which activities in the value chain are important to customers. Exhibit 2.3 (p. 29)
illustrates the business processes of the value chain.
The cost management information system also has two major subsystems: the cost accounting
information system and the operational control information system. The cost accounting information
system is a cost management subsystem designed to assign costs to individual products and services and
other objects of interest to managers. The operational control information system is designed to provide
accurate and timely feedback concerning the performance of managers and others relative to their
planning and control of activities. Exhibit 2.4 (p. 32) illustrates the various subsystems of the accounting
information system.
II. COST ASSIGNMENT: DIRECT TRACING, DRIVER TRACING, AND ALLOCATION
The section introduces and clarifies several concepts and terms relating to cost and the assignment of cost.
1. Cost: The cash or cash equivalent value sacrificed for goods and services that are expected to
bring a current or future benefit to the organization.
2. Expense: An expired cost or a cost used up in the production of revenues, such as the
merchandise inventory of a retailer. (But note that an unexpired cost is classified as an asset, and
if a cost expires without providing a benefit, it is classified as a loss.)
3. Cost object: Any item for which costs are measured and assigned. Examples include products,
customers, departments, projects, activities, and so on. For example, a bicycle is a cost object
when you are determining the cost to produce a bicycle.
4. Activity: A basic unit of work performed within an organization (e.g., setting up equipment,
moving materials, maintaining equipment, and designing products).
5. Indirect costs: Costs that cannot be easily and accurately traced to a cost object (e.g., the salary of
a plant manager, where departments within the plant are defined as the cost objects).
6. Direct costs: Costs that can be easily and accurately traced to a cost object (e.g., the salary of a
supervisor of a department, where the department is defined as the cost object, or bricks delivered
to a house that is being constructed by a contractor, where the house is the cost object).
7. Traceability: The ability to assign a cost to a cost object in an economically feasible way by
means of a causal relationship.
8. Direct tracing: The process of identifying and assigning costs to a cost object that are specifically
or physically associated with the cost object. This is the most precise method as it relies on
physically observable causal relationships.
10. Driver tracing: The use of drivers to assign costs to cost objects. The precision of driver tracing
depends on the strength of the causal relationship described by the driver.
11. Allocation: The assignment of indirect costs to cost objects. It is the least accurate cost
assignment method. Often, no causal relationship exists between the cost and the basis used to
assign the cost to the cost object.
III. PRODUCT AND SERVICE COSTS
One of the most important cost objects is the output of organizations. The two types of output are tangible
products and services. Tangible products are goods produced by converting raw materials through the use
of labor and capital inputs. Services are tasks or activities performed for a customer or an activity
performed by a customer using an organization’s products or facilities. Services differ from tangible
products on three important dimensions: intangibility, perishability, and inseparability. Intangibility
means that buyers of services cannot see, feel, hear, or taste a service before it is bought. Perishability
means that services cannot be stored (there are a few unusual cases where tangible goods cannot be
stored). Inseparability means that producers of services and buyers of services must usually be in direct
contact for an exchange to take place. Exhibit 2.5 (p. 36) provides three examples of product cost
definitions and some of the objectives they satisfy.
An important objective of a cost management system is the calculation of product costs for external
financial reporting. Costs are subdivided into two major functional categories: production and
nonproduction. Production (Product) costs are those costs associated with the manufacture of goods or
the provision of services. Nonproduction costs are those costs associated with the functions of selling and
administration.
Product costs can be further classified as direct materials, direct labor, and overhead. Direct materials are
those materials that are directly traceable to the goods or services being produced (e.g., the cost of tires on
an automobile). Direct labor is the labor that is directly traceable to the goods or services being produced
(e.g., wages of assembly-line workers). Overhead includes all other manufacturing costs not directly
traceable to the cost object (e.g., plant depreciation, utilities, property taxes, indirect materials, and
indirect labor). Prime cost is the sum of direct materials costs and direct labor costs. Conversion cost is
the sum of direct labor costs and overhead costs. An example of how and why to calculate prime cost,
conversion cost, and product cost is displayed in Cornerstone 2.1 (p. 39).
Nonproduction costs can be classified as marketing costs and administrative costs. Marketing costs are
the costs necessary to market, distribute, and service a product or service (e.g., commissions, storage
costs, and freight). Administrative costs are the costs associated with research, development, and general
administration of the organization that cannot reasonably be assigned to either marketing or production
(e.g., legal fees and the salary of the chief executive officer). Exhibit 2.6 (p. 41) illustrates the various
types of production and nonproduction costs.
IV. EXTERNAL FINANCIAL STATEMENTS
Production costs are assigned to products or services and do not become expenses until the point of sale.
Marketing and administrative costs are period costs and are deducted as an expense on the income
statement in the period incurred. Nonproduction costs do not appear on the balance sheet.
The income statement for a manufacturing firm is frequently referred to as absorption-costing income or
full-costing income. Under the absorption costing approach used to prepare the income statement,
expenses are separated according to function and then deducted from revenues to arrive at operating
income.
Cornerstones 2.2 (p. 42) and 2.3 (p. 43) present a statement of cost of goods manufactured and a
statement of cost of goods sold. This is a good time to discuss the flow of costs through the statement of
cost of goods manufactured to the income statement. Cornerstone 2.4 (p. 44) shows how the results of the
statement of cost of goods sold are included with nonmanufacturing expenses to calculate operating
income. Finally, these two examples provide students with enough skills to prepare an income statement
for a manufacturing firm.
Teaching hint: Ask the class how the income statements of merchandising firms and service firms will
differ. Classification of the expenses by function should be emphasized. The differences between income
statements of manufacturing firms and those of merchandising firms and service firms should be
discussed. Merchandising and service firms will not have a schedule of cost of goods manufactured. You
may want to present examples of an income statement of a manufacturing firm and an income statement
of a service provider.
V. TRADITIONAL AND ACTIVITY-BASED COST MANAGEMENT SYSTEMS
Cost management systems can be broadly classified as traditional or activity-based. Both traditional and
activity-based costing systems are widely used in practice. As both can be used in the same company, the
text integrates the treatment of the two types of costing systems.
A traditional cost accounting system assumes that all costs can be classified as fixed or variable with
respect to changes in production volume. Unit-based or volume-based drivers such as direct labor hours
or machine hours are used to assign production costs to products. Assignment of costs using unit-based
drivers does not consider all of the causal factors of cost incurrence and is therefore classified as
allocation. A traditional operation control system assigns costs to organizational units and then holds the
organizational unit manager responsible for controlling the assigned costs. Performance is measured by
comparing actual outcomes with standard or budgeted outcomes. The emphasis is on financial measures
of performance, and managers are rewarded for controlling costs.
An activity-based cost accounting system emphasizes tracing over allocation. Driver tracing includes the
use of non-unit-based activity drivers, which should increase the accuracy of cost assignments and the
overall relevance of cost information. The emphasis of the operation control system is management of
activities rather than costs. The emphasis of performance evaluation is on the organization as a whole
rather than subunits. Both financial and nonfinancial measures are used for evaluation purposes. Exhibit
2.7 (p. 49) displays an activity-based management model, while Exhibit 2.8 (p. 50) compares the
characteristics of the traditional and activity-based cost management systems.
In deciding to choose a cost management system, a manager must assess the trade-off between the cost of
measurement and the cost of errors. An activity-based cost management system offers significant
benefits, but is more complex and costly. Measurement costs are the costs associated with the
measurements required by the cost management system. Error costs are the costs associated with making
poor decisions based on bad cost information. Although the two costs conflict, an optimal cost
management system would minimize the sum of both. The trade-off between error and measurement costs
is illustrated in Exhibit 2.9 (p. 51). Another cost, which is increasing for some firms, is the cost of
unethical conduct. Exhibit 2.10 (p. 52) illustrates how changing error and measurement costs can make an
existing cost management system obsolete. As the exhibit illustrates, a more accurate cost management
system is mandated because of changes in error and measurement costs. Firms, then, should consider
implementing an activity-based management (ABM) system if they have experienced a decrease in
measurement costs and an increase in error costs.
VI. INFORMATION ABOUT EXERCISES, PROBLEMS, AND CASES
Exercises and problems are described below and on the following page according to coverage of content,
learning objective(s), and level of difficulty. The time required to solve the problems is roughly
proportional to the level of difficulty.
In general, basic exercises/problems are fairly simple and straightforward. The text material is relatively
brief; only one or two concepts are covered. Basic exercises and problems should take about 15 to 20
minutes each.
Moderate exercises/problems may take longer and involve more concepts. These problems may have a
“twist” and require more thought. Moderate exercises and problems may take 20 to 40 minutes each.
Challenging problems are more comprehensive and may cover more concepts. The text material is
relatively longer and may include some ambiguity. Challenging problems may take 60 to 90 minutes
each.
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Topic
Learning
Objective
Degree of
Difficulty
CS 2.1
Product Costs
LO 3
Basic
CS 2.2
Cost of Goods Manufactured
LO 4
Basic
CS 2.3
Cost of Goods Sold
LO 4
Basic
CS 2.4
Income Statement
LO 4
Basic
CS 2.5
Costs of Services
LO 3
Basic
CS 2.6
Cost of Services Produced
LO 4
Moderate
CS 2.7
Cost of Services Sold
LO 4
Moderate
CS 2.8
Income Statement
LO 4
Moderate
2.9
Systems Concepts
LO 1
Basic
2.10
Cost Accounting Information System
LO 1
Basic
2.11
Cost Assignment Methods
LO 2
Basic
2.12
Product Cost Definitions
LO 3
Basic
2.13
Cost Definitions
LO 3, 4
Basic
2.14
Cost Definitions and Calculations
LO 3, 4
Basic
2.15
Cost of Goods Manufactured and Sold
LO 4
Basic
2.16
Prime Cost, Conversion Cost, Preparation of Income
Statement: Manufacturing Firm
LO 3,4
Basic
2.17
Cost of Goods Manufactured and Sold
LO 4
Basic
2.18
Income Statement, Direct and Indirect Cost Concepts,
Service Company
LO 3, 4
Basic
2.19
Product Cost Definitions, Value Chain
LO 1
Basic
2.20
Traditional versus Activity-Based Cost Management
Systems
LO 5
Moderate
2.21
Direct Materials Cost, Prime Cost, Conversion Cost,
Cost of Goods Manufactured
LO 3, 4
Basic
2.22
Cost of Goods Sold, Income Statement
LO 4
Basic
2.23
CPA-Type Exercise
LO 1
Basic
2.24
CPA-Type Exercise
LO 1
Basic
2.25
CPA-Type Exercise
LO 4
Basic
2.26
CPA-Type Exercise
LO 1
Basic
2.27
CPA-Type Exercise
LO 4
2.28
Cost Assignment Methods
LO 3, 4
Moderate
2.29
Cost Information and Decision Making, Resource and
Activity Drivers, Activity-Based versus Traditional
Systems
LO 5
Moderate
2.30
Systems Concepts, Traditional versus Activity-Based
Cost Accounting Systems
LO 1, 5
Moderate
2.31
Activity-Based versus Traditional Operational Control
Systems
LO 1, 5
Moderate
2.32
Income Statement, Cost of Goods Manufactured
LO 3, 4
Moderate
2.33
Cost of Goods Manufactured, Cost Identification,
Solving for Unknowns
LO 2, 4
Moderate
2.34
Income Statement, Cost of Services Provided, Service
Attributes
LO 3, 4
Moderate
2.35
Cost of Goods Manufactured, Income Statement
LO 3, 4
Moderate
2.36
Product Cost Definitions, Ethics Case
LO 3
Moderate
2.37
Cyber Research Case
LO 2
Challenging
LIST OF ILLUSTRATIONS
Illustration
Topic
Exhibit 2.1
Operational Model of the Home-Theater System
Exhibit 2.2
Operational Model of an Accounting Information System
Exhibit 2.3
The Value Chain
Exhibit 2.4
Subsystems of the Accounting Information System
Exhibit 2.5
Examples of Product Cost Definitions
Exhibit 2.6
Production and Nonproduction Costs
Exhibit 2.7
Activity-Based Management Model
Exhibit 2.8
Comparison of Traditional and Activity-Based Cost Management Systems
Exhibit 2.9
Trade-Off between Measurement and Error Costs
Exhibit 2.10
Shifting Measurement and Error Costs