Solution manual cost accounting 8e by kinney

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CHAPTER

INTRODUCTION TO COST ACCOUNTING

1
Learning Objectives
After completing this chapter, you should be able to answer the following questions:
1. What are the relationships among financial, management, and cost accounting?
2. What are the sources of authoritative pronouncements for the practice of cost accounting?
3. What are the sources of ethical standards for cost accountants?
4. What is a mission statement, and why is it important to organizational strategy?
5. What must accountants understand about an organization’s structure and business environment to
perform effectively in that organization?
6. What is a value chain, and what are the major value chain functions?
7. How is a balanced scorecard used to implement an organization’s strategy?
8. Why is ethical behavior so important in organizations?

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Terminology
Authority: The right (usually by virtue of position or rank) to use resources to accomplish a task or

achieve an objective
Balanced scorecard: A framework that restates an organization’s strategy into clear and objective
performance measures focused on customers, internal business processes, employees, and
shareholders
Competence: Professional ethics standard that requires professionals to develop and maintain the skills
needed to practice their profession
Confidentiality: Professional ethics standard that requires professionals to refrain from disclosing
company information to inappropriate parties (such as competitors)
Core competency: Any critical function or activity in which an organization seeks a higher proficiency
than its competitors, making it the root of competitiveness and competitive advantage
Cost accounting: A discipline that addresses the demands of both financial and management
accounting by providing product cost information to (1) external parties (stockholders, creditors, and
various regulatory bodies) for investment and credit decisions and (2) internal managers who are
responsible for planning, controlling, decision making, and evaluation of performance
Cost leadership: A company’s ability to maintain its competitive advantage by undercutting competitor
prices
Credibility: Professional ethics standard that requires individuals to provide full, fair, and timely
disclosure of all relevant information in a given situation
Customer value perspective: The balanced scorecard perspective that addresses how well the
organization is doing relative to important customer criteria such as speed (lead time), quality, service,
and price (both purchase and after purchase)
Downstream cost: Costs such as marketing, distribution, and customer service which are typically
incurred after production of the product as opposed to upstream costs of research and development and
product design
Earnings management: The act of using accounting methods or practices to deliberately “adjust” a
company’s profit amount to meet a predetermined internal or external target
Environmental constraint: any limitation caused by external cultural, fiscal (such as taxation structures),
legal/regulatory, or political situations and by the competitive market structures that cannot be directly
controlled by management
Financial performance perspective: The balanced scorecard perspective that addresses the concerns

of stockholders and other stakeholders about profitability and organizational growth
Integrity: Professional ethics standard that prohibits individuals from participating in activities that would
discredit their company or profession
Intellectual capital: All of the intangible assets contained in an organization, including knowledge, skills,
and information that are used to create ideas for products and services, to train and develop employees,
and to attract and retain customers
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Internal business perspective: The balanced scorecard perspective that addresses those things that
the organization needs to do well to meet customer needs and expectations
Lag indicator: Historical financial data or other outcomes resulting from past actions, such as installing a
new production process or implementing a new software system
Lead indicator: Future financial and non-financial outcomes including opportunities and problems that
help an organization assess strategic progress and guide decision making before lag indicators are
known
Learning and growth perspective: The balanced scorecard perspective that focuses on using the
organization’s intellectual capital to adapt to changing customer needs or to influence new customer
needs and expectations through product or service innovations
Line personnel: Employees who work directly toward attaining organizational goals. Line personnel
are often held responsible for achieving targeted balanced scorecard measures or budgeted operating
income for their divisions or geographic regions; examples would include managers in production, sales,
and distribution
Management accounting: That part of accounting that is concerned with providing information to parties

inside an organization so that they can plan, control operations, make decisions, and evaluate
performance
Mission statement: A written expression of organizational purpose that describes how the organization
uniquely meets its targeted customers’ needs with its products or services
Organizational structure: Reflects the way in which authority and responsibility for making decisions is
distributed in an organization
Product Cost: The sum of the costs incurred within the factory to make one unit of product
Product differentiation: A company’s ability to offer superior quality products or more unique services
than competitors; such products and services, generally, are sold at a premium price
Responsibility: The obligation to accomplish a task or achieve an objective
Return on investment (ROI): A measure calculated as net income divided by total assets which was
used historically to allocate resources and evaluate divisional performance
Staff personnel: Employees who give assistance and advice to line personnel; examples include
employees in marketing, engineering, accounting, and finance
Strategy: The link between an organization’s goals and objectives and the activities actually conducted
by the organization
Upstream cost: Costs such as research and development and product design which are typically
incurred before production of the product as opposed to downstream costs of marketing, distribution, and
customer service
Value chain: The set of value-adding functions or processes that convert inputs into products and
services for the firm’s customers

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Lecture Outline
LO.1 What are the relationships among financial, management, and cost accounting?
A. Introduction
1. This chapter compares financial, management, and cost accounting, introduces the
organizational setting and environment in which the cost accountant must operate, and stresses
the importance of professional ethics.
B. Comparison of Financial, Management, and Cost Accounting
1. Financial Accounting
a. The objective of financial accounting is to provide useful information to external users of
financial statements including investors and creditors.
b. Financial accounting information is typically historical, quantitative, monetary, and verifiable
and usually reflects the activities of the whole organization.
c.

Financial accounting requires compliance with GAAP established by the FASB, the IASB,
and the SEC (or other influential organizations such as the APB and the AICPA).
i.

Publicly traded companies are required to have their financial statements audited by an
independent auditing firm.

ii.

Oversight of auditing standards for public companies is the responsibility of the Public
Company Accounting Oversight Board (PCAOB) which was created by the SarbanesOxley Act of 2002 (SOX) as a response to perceived abuses of accounting information by
corporate managers.

d. In the early 1900s, financial accounting was the dominant source of information for evaluating
business operations.

i.

ii.

Return on Investment (ROI) was one of the most popular performance measures:


ROI is calculated as Income divided by Total Assets.



ROI was a reasonable performance measure when companies were engaged in one
type of activity, operated primarily domestically, were labor intensive, and were
managed/owned by a small number of people.

As the securities market grew, so did the demand for audited financial statements.


The high cost of preparing financial reports due primarily to the lack of information
technology prevented organizations from developing a management accounting
system separate from the financial accounting system.

2. Management Accounting
a. Management accounting comprises the financial and nonfinancial information needed by
internal users (i.e., managers).
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Chapter 01: Introduction to Cost Accounting

i.

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Managers are concerned with fulfilling corporate goals, communicating and implementing
strategy, and coordinating product design, production, and marketing while
simultaneously running distinct business segments.

b. Management accounting information is not required to adhere to GAAP and thus can provide
both historical and forward-looking information to managers.
i.

c.

Management accounting information commonly addresses individual or divisional
concerns rather than those of the firm as a whole.

By the mid-1900s, companies were operating in a globally competitive, multiple product
environment.
i.

Trying to manage by using only financial reporting information often created dysfunctional
behavior and thus led to the need and demand for a management accounting system.


ii.

Introduction of reasonably priced information technology greatly aided the cause.

The differences between financial and management accounting are summarized in text
Exhibit 1-1 (p. 3).

d. To prepare plans, evaluate performance, and make more complex decisions, management
needed forward looking information and information on the organization’s upstream and
downstream costs.
i.

When making pricing decisions, managers needed to add these upstream and
downstream costs to the GAAP-determined product cost as illustrated in Exhibit 1–2 (p.
4).


Upstream costs are costs such as research and development and product design
which are typically incurred before production of the product.



Downstream costs include costs such as marketing, distribution, and customer
service which are typically incurred after production of the product.

3. Cost Accounting
a. Cost accounting information addresses the demands of both financial and management
accounting and is thus represented as the intersection of the financial and management
accounting systems (See text Exhibit 1-3 (p. 4)).
i.

Cost accounting supports the financial accounting system by providing product cost
information to external parties (stockholders, creditors, and various regulatory bodies) for

investment and credit decisions.


ii.

For external reporting purposes, GAAP defines product cost as the sum of the costs
incurred within the factory to make one unit of product.

Cost accounting supports the management accounting system by providing product cost
information to internal managers who are responsible for planning, controlling, decision
making, and evaluating performance.

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Chapter 01: Introduction to Cost Accounting


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For internal reporting purposes, product cost information can be developed outside
the constraints of GAAP to assist management with specific needs.

b. As companies expanded operations, managers recognized that a single cost could no longer
be computed for a product.
i.

For example, product costs could not easily be compared between multiple locations

when production processes were not similar in each location. Such complications
resulted in the evolution of the cost accounting database to include more than simply
financial accounting measures.

LO.2 What are the sources of authoritative pronouncements for the practice of cost accounting?
C. Cost Accounting Standards
1. The Institute of Management Accountants (IMA)
a. The IMA, a voluntary membership organization of accountants, finance specialists,
academics, and others, issues directives on the practice of management and cost
accounting.
i.

These directives, called Statements on Management Accounting (SMAs) are not legally
binding standards but they undergo a rigorous developmental and exposure process
that ensures wide support.

2. The Society of Management Accountants of Canada
a. The IMA counterpart in Canada also issues guidelines on the practice of management
accounting called Management Accounting Guidelines (MAGs) and again, while not
mandatory, do represent best practices for high-quality organizational accounting.
3. The Cost Accounting Standards Board (CASB)
a. The CASB is a public sector body established in 1970 to issue uniform cost accounting
standards for defense contractors and federal agencies.
b. The CASB produced 20 cost accounting standards (one of which has been withdrawn) from
its inception until it was terminated in 1980.
c.

The CASB was recreated in 1988 as an independent board of the Office of Federal
Procurement Policy to help ensure uniformity and consistency in government contracting.

d. CASB standards do not constitute a comprehensive set of rules, but compliance is required
for companies bidding on or pricing cost-related contracts with the federal government.
4. No official agency publishes generic management accounting standards for all companies.
a. Although the IMA, Society of Management Accountants of Canada, and CASB have been
instrumental in standards development, much of the body of knowledge and practice in
management accounting has been provided by industry practice and economic and finance
theory.

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LO.3 What are the sources of ethical standards for cost accountants?
D. Professional Ethics
1. Managers achieve their financial targets by concentrating on acquiring a targeted market
share and desired levels of customer satisfaction.
2. However, executives at some companies (e.g., WorldCom (now MCI), Enron, Tyco, and
HealthSouth) have exhibited unethical behavior in trying to “make their numbers.”
a. Earnings management involves using an accounting method or practice to deliberately
adjust a company’s profit amount to meet earnings estimates, preserve a specific
earnings trend, convert a loss to a profit, increase management compensation, or hide
illegal transactions, for example.
b. Aggressive Accounting involves exceeding the boundaries of reason in applying
accounting principles in order to meet a predetermined internal or external target.
3. The Sarbanes-Oxley Act of 2002 was passed to hold CEOs and CFOs personally

accountable for the accuracy of their organization’s financial reporting.
a. Under SOX, chief financial officers who knowingly certify false financial reports may be
punished with a maximum penalty of a $5 million fine, 20 years in prison, or both.
4. Certified Management Accountants (CMA) must adhere to the standards of ethical conduct
published in the Statement of Ethical Professional Practice issued by the IMA.
5. The IMA’s Code of Ethics (See text Exhibit 1–4 (p. 6)) has four standards:
a. Competence means that individuals will develop and maintain the skills needed to
practice their profession.
b. Confidentiality means that individuals will refrain from disclosing company information to
inappropriate parties (such as competitors) that could be specifically defined in the
company’s code of ethics.
c.

Integrity means that individuals will not participate in activities that would discredit their
company or profession.

d. Credibility means providing full, fair, and timely disclosure of all relevant information.
6. Cost and management accountants who discover illegal or immoral behavior such as
financial fraud, theft, environmental violations, or employee discrimination should evaluate
the situation and, if appropriate, “blow the whistle” on the activities by disclosing them to
appropriate persons or agencies.
a. The accountant should keep the information confidential and report it to his/her
immediate supervisor (unless that person is suspected of being involved).
b. The accountant should continue up the chain of command to the first manager who is not
involved in the situation —meaning that it could be necessary to take the matter all the
way to the audit committee of the board of directors.
c.

If the matter cannot be resolved, the only recourse available may be to resign and consult
a legal adviser before reporting the matter to regulatory authorities.

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LO.4 What is a mission statement and why is it important to organizational strategy?
E. Compteting in a Global Environment
1. General
a. A mission statement expresses the purposes for which the organization exists, what the
organization wants to accomplish, and how its products and services can uniquely meet its
targeted customers’ needs.
b. Mission statements are used to develop the organization’s strategy or plan of how the firm
will fulfill its goals and objectives and achieve an advantage over its competitors.
2. Organizational Strategy (see text Exhibit 1-5 (p. 8))
a. A core competency is any critical function or activity such as technological innovation,
engineering, product development, and after-sale service in which an organization seeks a
higher proficiency than its competitors, making it the root of competitiveness and competitive
advantage.
b. Most companies compete using either a “cost leadership” or “product differentiation” strategy.

c.

i.

Cost leadership refers to a company’s ability to maintain its competitive edge by

undercutting competitor prices (e.g., Wal-Mart).

ii.

Product differentiation refers to a company’s ability to offer superior quality products or
more unique services than competitors; such products and services are, however,
generally sold at premium prices. (e.g., Rolex watches).

Cost accountants gather financial and nonfinancial information to help management achieve
organizational strategy. Text Exhibit 1–6 (p. 9) provides a checklist of questions that help
indicate whether an organization has a comprehensive strategy in place.

LO. 5 What must accountants understand about an organization’s structure and business
environment to perform effectively in that organization?
F. Organizational Structure
1. An organization is composed of people, resources other than people, and commitments that are
acquired and arranged to achieve organizational strategy and goals.
2. Organizational structure reflects the way in which authority and responsibility for making
decisions are distributed in an organization.
a. Authority refers to the right (usually by virtue of position or rank) to use resources to
accomplish a task or achieve an objective.
b. Responsibility is the obligation to accomplish a task or achieve an objective.
3. Work in organizations is directed by line personnel who work directly toward attaining
organizational goals, and staff personnel who give assistance and advice to line managers.
a. The treasurer is generally responsible for achieving short- and long-term financing, investing,
and cash management goals.

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b. The controller is responsible for delivering to management financial reports in conformity
with GAAP.
4. Management style, the way managers interact with the entity’s stakeholders, especially
employees, impacts the organization’s decision-making processes, risk taking, willingness to
encourage change, and employee development.
5. Organizational culture refers to the basic manner in which the organization interacts with its
business environment, the way in which employees interact with each other and with
management, and the underlying beliefs and attitudes held by employees about the organization.
6. Short-term organizational constraints that may be overcome by existing business opportunities:
a. Monetary capital. If additional capital cannot be obtained at a reasonable cost management
must determine how to reallocate existing capital in an effective and efficient manner.
b. Intellectual capital, which encompasses the knowledge, skills, and information that an
organization possesses, impacts the firm’s ability to create ideas for products or services, to
train and develop its employees, and to attract and retain customers.
c.

Technology. Companies must adopt emerging technologies to stay at the top of their
industry and achieve a competitive advantage over competitors.

7. An environmental constraint is any limitation caused by external cultural, fiscal (such as
taxation structures), legal/regulatory, or political situations and by competitive market structures.
LO. 6 What is a value chain, and what are the major value chain functions?
G. Value Chain
1. The value chain is a set of value-adding functions or processes that convert inputs into products

and services for the organization’s customers (See text Exhibit 1–7 (p. 11)):
a. Research and Development—experimenting to reduce costs or improve quality.
b. Design—developing alternative product, service, or process designs.
c.

Supply—managing raw materials received from vendors to reduce costs and improve quality.

d. Production—acquiring and assembling resources to produce a product or render a service.
e. Marketing—promoting a product or service to current and prospective customers.
f.

Distribution—delivering a product or service to a customer.

g. Customer Service—supporting customers after the sale of a product or service.
2. Cost accountants help design the communication network that is used to communicate corporate
strategy to all members in the value chain so that the strategy can be effectively implemented.

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LO.7 How is a balanced scorecard used to implement an organization’s strategy?
H. Balanced Scorecard
1. Firms use a portfolio of lag and lead indicators to determine not only how the organization has
performed in the past but also how it is likely to perform in the future.

a. Lag indicators which are historical financial data that reflect outcomes that have resulted
from past actions, such as installing a new production process or implementing a new
software system, are often recognized and assessed too late to significantly improve current
or future actions.
b. Lead indicators which reflect future financial and nonfinancial outcomes (including
opportunities and problems) help managers assess strategic progress and guide decision
making before lag indicators are known.
2. Organizations often use both lead and lag indicators in a balanced scorecard to assess strategy
congruence.
3. The balanced scorecard (BSC) is a framework that restates an organization’s strategy into clear
and objective performance measures focused on customers, internal business processes,
employees, and shareholders.
4. The BSC includes long-term and short-term, internal and external, financial and nonfinancial
measures to balance management’s view and execution of strategy.
5. As illustrated in text Exhibit 1–8 (p. 13), the balanced scorecard has four perspectives:
a. The learning and growth perspective focuses on using the organization’s intellectual
capital to adapt to changing customer needs or to influence new customers’ needs and
expectations through product or service innovations.
b. The internal business perspective focuses on those things that the organization needs to
do well to meet customer needs and expectations.
c.

The customer value perspective addresses how well the organization is doing relative to
important customer criteria such as speed (lead time), quality, service, and price (both
purchase and after purchase).

d. The financial perspective addresses the concerns of stockholders and other stakeholders
about profitability and organizational growth.
6. See text Exhibit 1–9 (p. 14) for a more realistic and more complicated balanced scorecard.

LO.8 Why is ethical behavior so important in organizations?
I.

Ethics in Multinational Corporations
1. Accountants and other individuals working for multinational companies should be aware of not
only their company’s and the IMA’s code of ethical conduct but also the laws and ethical
parameters within countries in which the multinational operates.
2. The Foreign Corrupt Practices Act (FCPA) of 1977 prohibits U.S. corporations from offering or

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giving bribes (directly or indirectly) to foreign officials to influence those individuals (or cause them
to use their influence) to help businesses obtain or retain business.
3. The Organization of Economic Cooperation and Development (OECD) has released a document
that makes it a crime to offer, promise or give a bribe to a foreign public official in order to obtain
or retain international business deals.
a. As of March 2008, 37 countries (see Text Exhibit 1–10 (p. 15)) had signed this document,
including the United States.
b. Signing the OECD convention illustrates that companies globally are beginning to
acknowledge that bribery should not be considered an appropriate means of doing business.

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Multiple Choice Questions
1. (LO.1) Select the incorrect comparison between financial and management accounting:

a.
b.
c.
d.

Primary focus
Overriding criteria
Information timeframe
Recordkeeping

Financial Accounting
External
Verifiability
Historical
Formal

Management Accounting
Internal
GAAP
Current/future

Formal and informal

2. (LO.1) Oversight of auditing standards for public companies is the responsibility of the
a.
Public Company Accounting Oversight Board.
b.
Securities and Exchange Commission.
c.
Financial Accounting Standards Board.
d.
Institute of Management Accountants.
3, (LO.1) The acronym IASB stands for
a.
Internal Accounting Standards Board.
b.
Internal Auditing Standards Board.
c.
International Auditing Standards Board.
d.
International Accounting Standards Board.
4. (LO.1) Cost accounting can best be described as
a.
the intersection between financial and management accounting.
b.
a system that meets the informational demands of both financial and management
accounting.
c.
a system that provides product cost information to Internal managers for planning,
controlling, decision making and evaluating performance.
d.

all of the above.
5. (LO.2) Statements on Management Accounting (SMA) are directives on the practice of
management and cost accounting. Select the incorrect statement concerning SMAs from the
following.
a.
SMAs are issued by the Cost Accounting Standards Board.
b.
SMAs are not legally binding.
c.
SMAs go through a rigorous developmental and exposure process.
d.
SMAs describe high-quality or best practices in management accounting.
6. (LO.3) A management accountant who fails to perform professional duties in accordance with
relevant standards is acting contrary to which of the following standards?
a.
Competency
b.
Integrity
c.
Objectivity
d.
Confidentiality
7. (LO.3) The IMA Code of Ethics requires a management accountant to follow the established
policies of the organization when facing an ethical conflict. When management accountants fail
to resolve an ethical conflict by talking with their immediate supervisor they should
a.
communicate the problem to authorities outside the organization.
b.
contact the next higher managerial level.
c.

notify the audit committee of the board of directors.
d.
contact the chief financial officer.

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Chapter 01: Introduction to Cost Accounting

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8. (LO.3) According to the IMA Code of Ethics a practitioner has the responsibility to recognize
professional limitations. Under which standard of ethical conduct would this responsibility be
included?
a.
Competency
b.
Confidentiality
c.
Integrity
d.
Objectivity
9. (LO.4) Strategic planning includes all of the following except:
a.
top-level management participation.
b.
a long-term focus.
c.

analysis of the current month’s actual variances from budget.
d.
identification of long-term key variables including external influences.
10. (LO.4) The strategy that is being used by a company that seeks to provide superior quality
products or more unique services than its competitors is a
a.
cost leadership strategy.
b.
differentiation strategy.
c.
customer value strategy.
d.
value chain strategy.
11. (LO.5) All of the following are staff personnel except:
a.
production supervisor.
b.
cost accountant.
c.
corporate controller.
d.
tax accountant.
12. (LO.5) An organization’s collection of knowledge, skills, and information is referred to as its
a.
political capital.
b.
qualitative capital.
c.
intangible capital.
d.

intellectual capital.
13. (LO.6) All of the following are examples of upstream functions in the value chain except
a.
supply.
b.
research and development.
c.
production.
d.
design.
14. (LO.7) Which balanced scorecard perspective focuses on those things that the organization must
do well to meet customer needs and expectations?
a.
Customer perspective
b.
Learning and growth perspective
c.
Financial perspective
d.
Internal business perspective
15. (LO.8) Which of the following is a violation of the Foreign Corrupt Practices Act?
a.
Paying cash bribes to foreign officials
b.
Giving sporting event tickets to foreign officials
c.
Providing free samples to the families of foreign officials
d.
All of the above

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Multiple Choice Solutions
1.

b

2.

a

3.

d

4.

d

5.

a

6.

a (CMA Adapted)

7.

b (CMA Adapted)

8.

c (CMA Adapted)

9.

c (CMA Adapted)

10.

b

11.

a

12.

d

13.

c

14.

d

15.

d

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CHAPTER

2

COST TERMINOLOGY AND COST
BEHAVIORS

Learning Objectives
After reading and studying Chapter 2, you should be able to answer the following questions:
1. Why are costs associated with a cost object?
2. What assumptions do accountants make about cost behavior, and why are these assumptions
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?

5. What are the product cost categories, and what items comprise those categories?
6. How and why does overhead need to be allocated to products?
7. How is cost of goods manufactured calculated and used in preparing an income statement?

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Chapter 02: Cost Terminology and Cost Behaviors

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Terminology
Actual cost system: A costing system that charges Work in Process Inventory with the actual direct
material, direct labor, and overhead costs of producing a product
Appraisal costs: Costs incurred to find mistakes not eliminated through prevention
Conversion costs: The costs (direct labor and overhead) required to convert direct material into a
finished good or service
Cost: The monetary measure of resources given up to attain an objective such as producing a product or
providing a service
Cost allocation: The assignment of an indirect cost to one or more cost objects using some reasonable
allocation base or driver
Cost driver: A factor that has an absolute cause-effect relationship to a cost
Cost management system (CMS): A set of formal methods developed for planning and controlling an
organization’s cost-generating activities relative to its strategy, goals, and objectives
Cost object: Anything for which management wants to collect or accumulate costs
Cost of goods manufactured (CGM): The total cost of the goods completed and transferred to Finished
Goods Inventory during the period
Direct costs: Costs which are conveniently and economically traceable to a particular cost object

Direct labor: Labor costs of individuals who work specifically on manufacturing a product or performing a
service
Direct material: Material costs that can be easily and economically traced to a product
Distribution cost: Any cost incurred to warehouse, transport, or deliver a product or service
Expired cost: The portion of an asset’s value that has been consumed or sacrificed during the period
and which is reported as an expense or loss on the income statement
Failure costs: Internal costs (e.g., scrap and rework) and external costs (e.g., product returns, warranty
costs, complaints to customer service) caused by quality problems
Finished goods: The costs of units of inventory that have been fully completed
Fixed cost: A cost that remains constant in total within the relevant range of activity but varies on a unit
basis
Indirect costs: Costs that cannot be economically traced to a particular cost object and therefore must
be allocated to the object instead
Inventoriable costs: The direct costs of materials and labor plus the indirect costs of overhead which
become part of the cost of inventory

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Chapter 02: Cost Terminology and Cost Behaviors

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Manufacturer: A company engaged in a high degree of conversion of raw material that results in a
tangible output
Mixed cost: A cost that has both a variable and a fixed component and that changes with changes in
activity, but not proportionately
Normal cost system: A costing system that charges the Work in Process Inventory with the actual costs

of direct material and direct labor and an assigned amount of overhead based on a predetermined
overhead rate
Overhead: Any factory or production cost that is indirect to the product or service (that is, a productionrelated cost that cannot be directly traced to the product)
Period costs: Costs related to business functions other than production (such as selling and
administrative costs) which are expensed in the current accounting period
Predetermined overhead rate: A charge per unit of activity used to allocate or apply overhead cost from
the Overhead Control account to Work in Process Inventory for the period’s production or services
Predictor: An activity measure that, when changed, is accompanied by consistent, observable changes
in a cost item
Prevention costs: Costs incurred to improve quality by precluding product defects and improper
processing from occurring
Prime costs: The primary costs (direct material and direct labor) of producing a product or delivering a
service
Product costs: Costs associated with making or acquiring the products or providing the services that
directly generate the revenues of an entity
Raw material: The materials used in the production process. From the standpoint of conversion, raw
material represents work not yet started
Relevant range: The assumed range of activity that reflects the company’s normal operating range and
over which unit variable costs and total fixed costs are assumed to remain constant
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)
activity. Step variable costs have small steps and step fixed costs have large steps
Total cost to account for: The sum of the beginning WIP Inventory and the total current manufacturing
costs (DM, DL, OH)
Unexpired cost: The portion of an asset’s value that has not yet been consumed or sacrificed and which
is reported on the balance sheet as an asset
Variable cost: A cost that varies in total proportionately with changes in activity but which is a constant
amount per unit
Work in process: The costs of work started but not yet completed

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Chapter 02: Cost Terminology and Cost Behaviors

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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
management accounting information. The chapter also presents cost flows and the process of
cost accumulation in a production environment.
2. To effectively communicate information, accountants must clearly understand the differences
among the various types of costs, their computations, and their usage.
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.
a. Cost reflects the monetary measure of resources given up to attain an objective such as
making a good or delivering a service.
b.

Unexpired cost: The portion of an asset’s value that has not yet been consumed or
sacrificed and which is reported on the balance sheet as an asset.

c.

Expired cost: The portion of an asset’s value that has been consumed or sacrificed during
the period and which is reported as an expense on the income statement.

B. Cost Terminology
1. A cost management system is a set of formal methods developed for planning and controlling
an organization’s cost-generating activities relative to its strategy, goals, and objectives.
2.

Some important types of costs are summarized in text Exhibit 2–1 (p. 25).

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.
b. The costs associated with any cost object can be classified according to their relationship to
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 Tundra pickup truck is a
direct cost when the cost object is the Tundra product.

d. Indirect costs are costs that cannot be economically traced to the cost object but instead
must be allocated to the cost object.
i.

For example, the cost of glue used to manufacture a Tundra pickup truck is an indirect
cost when the cost object is the Tundra pickup truck.

e. Costs may be direct or indirect depending upon the cost object.
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Chapter 02: Cost Terminology and Cost Behaviors

i.

IM 5

As above, the glue used used to manufacture a Tundra pickup truck is an indirect cost
when the cost object is the Tundra pickup truck but is a direct cost when the cost object is
the Princeton plant in which the Tundra is manufactured.

LO.2 What assumptions do accountants make about cost behavior, and why are these
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
cost) reacts to changes in a related activity measure over the relevant range.
b. Common activity measures include production volume, service and sales volumes, hours of
machine time used, pounds of material moved, and number of purchase orders processed.
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
is constant on a unit basis. Although accountants view variable costs as linear,
economists view these costs as curvilinear as shown in text Exhibit 2–2 (p. 27).

ii.

A fixed cost is a cost that remains constant in total within the relevant range of activity
but varies inversely with changes in the level of activity on a per unit basis. The variable
and fixed cost behavior patterns are summarized in text Exhibit 2–3 (p. 28).

iii.

A mixed cost has both a variable and a fixed component as illustrated in text Exhibit 2-4
(p. 28). Mixed costs must be separated into their variable and fixed components in order
to make valid estimates of total costs at various activity levels.

e. Management may decide to “trade” fixed and variable costs for one another.

f.

i.

For example, installing new automated production equipment would result in an
additional large fixed cost for depreciation but would eliminate the variable cost of wages

for hourly production workers.

ii.

A shift from one type of cost behavior to another type changes a company’s basic cost
structure and can have a significant impact on its profits.

A step cost is a cost that shifts upward or downward when activity changes by a certain
interval or “step.” Step costs can be variable or fixed; step variable costs have small steps
while step fixed costs have large steps.

g. Assuming a variable cost is constant per unit and a fixed cost is constant in total within the
relevant range can be justified for two reasons:

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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
provides a convenient, stable measurement for use in planning, controlling, and decision
making activities.

h. Selection of an appropriate activity measure is important.
i.

A predictor is an activity measure that, when changed, is accompanied by consistent,
observable changes in a cost item. However, simply because two items change together
does not prove that the predictor causes the change.

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. 30) illustrates the linear cause-and-effect relationship between
production volume and total raw material cost.

iv.

Traditionally, a single predictor has often been used to predict costs but accountants and
managers are realizing that single predictors do not necessarily provide the most reliable
forecasts, thus causing a movement toward activity-based costing, which uses multiple
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’
capital whereas the income statement is a statement of revenues and expired costs
(expenses and losses).
b. The matching concept provides a basis for deciding when an unexpired cost becomes an
expired cost and is moved from an asset category to an expense or loss category.
c.

When the product is specified as the cost object, all costs can be classified as either product
or period costs.

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.
i. Direct material is any material that can be easily and economically traced to a product.
ii. Direct labor refers to the time spent by individuals who work specifically on manufacturing
a product or performing a service.
iii. Overhead is any factory or production cost that is indirect (i.e., not direct material or direct
labor) to the product or service.

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e. The sum of direct labor and overhead costs is referred to as conversion cost as those are
the costs incurred to convert materials into products.

f.

The sum of direct material and direct labor cost is referred to as prime cost as those are the
primary costs in making most products.

g. Period costs are related to business functions other than production, such as selling and
administration.
i.

Period costs are generally more closely associated with a particular time period than with
making or acquiring a product or performing a service.

ii. Period costs that have future benefit are classified as assets, whereas those having no
future benefit are expenses. For example, prepaid insurance (asset) becomes insurance
expense.
iii. Distribution costs are period costs incurred to warehouse, transport, or deliver a
product or service.
LO.4

How does the conversion process occur in manufacturing and service companies?

D. The Conversion Process
1.

General
a. In general, product costs are incurred in the production (or conversion) area and period costs
are incurred in all nonproduction (or nonconversion) areas.
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.

d. Firms that engage in only low or moderate degrees of conversion (such as retailers) can
conveniently expense insignificant costs of labor and overhead related to conversion.
e. In high-conversion firms, the informational benefits gained from accumulating the material,
labor, and overhead costs incurred to produce outputs significantly exceed clerical
accumulation costs as illustrated in text Exhibit 2-7 (p. 32).
f.

A manufacturer is defined as any company engaged in a high degree of conversion of raw
material input into a tangible output using people and machines.

g. A service company refers to a for-profit business or not-for-profit organization that uses a
significant amount of labor to engage in a high or moderate degree of conversion, whose
outputs can be tangible (e.g., an architectural drawing) or intangible (e.g., insurance
protection).
2.

Retailers versus Manufacturers/Service Companies
a. Retail companies purchase goods in finished or almost finished condition so those goods
typically need little, if any, conversion before being sold to customers.

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b. In comparison, manufacturers and service companies engage in activities that involve the
physical transformation of inputs into, respectively, finished products and services.
c.

A cost accounting system is required to assign the materials or supplies and conversion costs
of manufacturers and service companies to output to determine the cost of inventory
produced and cost of goods sold or services rendered.

d. The production or conversion process occurs in three stages:
i.

Work not started (raw material);

ii.

Work started but not completed (work in process); and

iii.

Work completed (finished goods).

e. Text Exhibit 2–8 (p. 33) compares the input–output relationships of a retail company with
those of a manufacturing/service company.
i.

f.

3.

As shown in the exhibit, unlike manufacturers and service firms, retail firms have no
“production center” where input factors such as raw material enter and are transformed
and stored until the goods or services are completed.

Text Exhibit 2–9 (p. 35) depicts some of the costs associated with each stage of the
conversion process.
i.

In the first stage of processing, the costs incurred reflect the prices paid for raw materials
and/or supplies.

ii.

As work progresses through the second stage, accrual-based accounting requires that
labor and overhead costs related to the conversion of raw materials or supplies be
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.

Manufacturers versus Service Companies
a. In a service firm, the work not started stage of processing normally consists of the cost of
supplies needed to perform the services (Supplies Inventory).
i.

When supplies are placed into process, labor and overhead are added to achieve
finished results. Thus, some service firms use two accounts (a Supplies Inventory

account and a Work in Process Inventory account) to accumulate these costs.

b. Manufacturers use three inventory accounts: (1) Raw Material Inventory (instead of
Supplies), (2) Work in Process Inventory (for partially converted goods), and (3) Finished
Goods Inventory.
c.

Because services generally cannot be warehoused, costs of finished jobs are usually
transferred immediately to the income statement to be matched against service revenue
rather than being carried on the balance sheet in a finished goods inventory account.

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d. All organizations (retailers, manufacturers, and service firms) need management and cost
accounting techniques to help them find ways to reduce costs without sacrificing quality or
productivity.

LO.5

What are the product cost categories, and what items comprise those categories?

E. Components of Product Cost
1. Direct Material

a. Direct material cost includes the cost of all materials used to manufacture a product or
perform a service.
b. Material costs that are not conveniently or economically traceable are classified as indirect
costs and included in overhead.
c.

See text Exhibit 2–9 (p. 35) for an example of direct vs. indirect material costs.

2. Direct labor
a. Direct labor refers to the effort of individuals who manufacture a product or perform a service.
b. Direct labor cost consists of the wages or salaries paid to direct labor personnel conveniently
traceable to the product or service.
i.

c.

Direct labor should include basic compensation, production efficiency bonuses, the
employees’ share of Social Security and Medicare taxes, and if the company’s operations
are relatively stable, all employer-paid insurance costs, holiday and vacation pay, and
pension and other retirement benefits.

Labor costs that cannot be reasonably or economically traced are classified as indirect costs
and included in overhead.
i.

Although fringe benefit costs should be treated as direct labor, the time, effort, and
clerical expense of tracing such costs to production do not warrant such treatment.

ii.

Costs for overtime or shift premiums are usually considered overhead rather than direct
labor cost and are allocated among all units unless the overtime costs resulted from
expediting a customer’s request.

d. Because laborers historically performed the majority of conversion activity, direct labor once
represented a large portion of total manufacturing cost.
i. Now, in highly automated work environments, direct labor often represents only 10 to 15
percent of total manufacturing cost.
3. Overhead
a. Overhead is any factory or production cost that is indirect to manufacturing a product or
providing a service.

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b. Overhead includes indirect material, indirect labor and other production-related costs such as
factory depreciation, factory utilities, factory insurance, etc.
c.

Automated and computerized technologies have made manufacturing more capital intensive
and overhead has become a progressively larger proportion, and such costs merit much
more attention than they did in the past.

d. Variable overhead includes the costs of indirect material, indirect labor paid on an hourly

basis, lubricants used for machine maintenance, and the variable portion of factory utility
charges.
e. Fixed overhead includes costs such as straight-line depreciation on factory assets, factory
license fees, factory insurance and property taxes, and fixed indirect labor costs such as
salaries for production supervisors, shift superintendents, and plant managers.
f.

Quality costs are an important component of overhead cost since high-quality products or
services enhance a company’s ability to generate revenues and produce profits. Managers
are concerned about production process quality because higher process quality leads to
shorter production time and reduced costs for spoilage and rework.
i.

Prevention costs are incurred to improve quality by precluding product defects and
improper processing from occurring.

ii.

Appraisal costs are costs incurred for monitoring or inspecting products in order to find
mistakes not eliminated through prevention.

iii.

Internal Failure costs are costs such as scrap and rework that result when quality
problems are detected before the product reaches the final customer.

iv.

External Failure costs are incurred when quality problems are not discovered until after
the product has been delivered to the final customer and include costs such as product

returns and warranty claims.

g. Some quality costs are variable in relation to the quantity of defective output, some are step
fixed with increases at specific levels of defective output, and some are fixed for a specific
time.

LO.6

How and why does overhead need to be allocated to products?

F. Accumulation and Allocation of Overhead
1. General
a.

To satisfy the historical cost and matching principles, which require that all production or
acquisition costs attach to the units produced or purchased, overhead must be
accumulated over a period and allocated to the products manufactured or services
rendered during that period.

b.

Cost allocation refers to the assignment of an indirect cost to one or more cost objects
using some reasonable allocation base or driver.

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