Chapter 4

Cost Terminology and

Cost Flows

Learning Objectives
1. What is the relationship between cost objects and
direct costs?
2. How do you classify product costs into direct
materials, direct labor, and factory overhead
categories?

C4

Continuing . . . Learning Objectives

3. How does the conversion process work in
manufacturing and service companies?
4. What are the assumptions accountants make about
cost behavior and why are these assumptions
necessary?

C4

Continuing . . . Learning Objectives

5. How can mixed costs be analyzed using the high-low
method and (Appendix) least-squares regression
analysis?
6. What is the usefulness of flexible budgeting to
managers?

C4

Continuing . . . Learning Objectives

7. How are predetermined factory overhead rates developed and
how does the selection of a capacity measure affect factory
overhead application?
8. How is underapplied or overapplied factory overhead
accounted for at year-end and why are these accounting
techniques appropriate?

C4

Continuing . . . Learning Objectives

9.

Why are separate predetermined

overhead rates generally more useful than

combined rates?
10.

How is cost of goods manufactured

calculated?

C4

Cost Classification Categories

Time of incurrence
Reaction to changes in activity
Classification on the financial
statements
Impact on decision making
Type of sacrifice

Continuing . . .
Cost Classification Categories
Cost Classification

Associated
with time of
incurrence

Types of Costs

Historical (past)
Replacement (present)
Budgeted (future)

Continuing . . .
Cost Classification Categories
Cost Classification

Types of Costs

Cost behavior:
reaction to
changes in
activity

Variable (fluctuates in total)

Fixed (constant in total)
Mixed (part variable;
part fixed)

Continuing . . .
Cost Classification Categories
Cost Classification
Classification
on the
financial
statements

Types of Costs
Unexpired (balance sheet)
Expired (income statement)
Product (inventoriable)
Direct (traceable)
Indirect (nontraceable)
Prime
Conversion
Period (expensed)

Continuing . . .
Cost Classification Categories
Cost Classification
Impact on
decision
making

Types of Costs
Relevant (important)
Quality (conformity)
Prevention
Appraisal
Failure

Continuing . . .
Cost Classification Categories
Cost Classification

Types of Costs

Type of
sacrifice

Out-of-pocket (cash)
Sunk (historical)
Opportunity (foregone benefit)

Components of Product Cost

Product costs relate to the products or services
that generate an entitys revenues. These costs
are either direct or indirect in relation to a
particular cost object.
Costs that are clearly traceable to the cost object are
called direct costs.
Costs that cannot be traced to the cost object are
indirect (or common) costs.

Direct Material
Readily identifiable,
physical part of a
product
Clearly, conveniently,
and economically
traceable to a
product

Direct Labor
Individuals who work on product or
perform service
Basic compensation
Production efficiency bonuses
Employers share of Social Security
and Medicare taxes
Employer-paid insurance costs,
holiday and vacation pay, and
retirement benefits only if
operations are relatively stable

Factory Overhead
Any factory or production cost that is not directly
or conveniently traceable to manufacturing a
product or providing a service

Behavior of Product Costs

Direct Material
Variable

Direct Labor
Generally variable

Factory Overhead
Some variable
Some fixed

Prime Cost
Prime Cost = Direct Material + Direct Labor

Conversion Cost
Conversion Cost = Direct Labor + Factory Overhead

Stages of Production
Production processing or conversion can
be viewed as existing in three stages:
1. Work not started (raw materials)
2. Work in process
3. Finished work

Determining Cost Behavior

Cost driver
Activity has a direct cause-effect relationship with a
cost

Cost predictor
Activity is accompanied by consistent, observable
changes in a cost.

Basic Cost Graph

y
Total
Cost

x
Activity Level

Relevant Range

Total
Cost

Activity Level

Variable Cost

Total
Cost

y = bx
b = slope of line

Activity Level

Fixed Cost
y=a
a = y intercept

Total
Cost

Activity Level

Total Cost

Total
Cost

y = a + bx

Activity Level

Mixed Cost

Total
Cost

Activity Level

Step Cost

Total
Cost

Activity Level

Step Variable Cost

Total
Cost

Activity Level

Step Fixed Cost

Total
Cost

Activity Level

High-Low Method
Cost estimation technique for separating mixed
cost into variable and fixed components
Uses activity and cost information
Select highest and lowest activity levels--if
within relevant range
Used to develop y = a + bx

High-Low Analysis
of Utility Cost: Step 1
MONTH

LEVEL OF
ACTIVITY

UTILITY
COST

January
February
March
April
May
June
July

11,300
11,400
9,000
11,500
11,200
10,100
12,200

$1,712
1,716
1,469
1,719
1,698
1,691
1,989

High-Low Analysis
of Utility Cost: Step 2
Cups of
Coffee
High activity April
Low activity March
Changes

11,500

Associated
Utility Cost
$1,719

9,000
2,500
====

1,469
$ 250
=====

High-Low Analysis
of Utility Cost: Step 3

Change in total cost

$ 250
b=
=
Change in activity volume
2,500

= $.10 per cup

High-Low Analysis
of Utility Cost: Step 4
High level of activity: TVC = $.10 (11,500) = $1,150

OR
Low level of activity: TVC = $.10 (9,000) = $ 900

High-Low Analysis
of Utility Cost: Step 5
High level of activity:

a = $1,719 - $1,150 = $569

====

OR
Low level of activity:

a = $1,469 - $900 = $569

====

High-Low Analysis
of Utility Cost: Step 6
y = $569 + $.10x
where x = number of cups of coffee

Preparing a Flexible Budget

Analyze overhead as to cost behavior
Find variable, fixed, and mixed costs

Separate each mixed cost into variable

and fixed components
Use cost formula (y = a + bx) for each
mixed cost

Prepare a series of individual financial

plans that detail the individual costs at
different levels of activity

Flexible Budget
# of Units
Variable Cost
Fixed Cost

5,000
$1.85
$3,500

Variable Cost $8,750

Fixed Cost
3,500
Total Cost
$12,250
======

7,000
$1.85
$5,200

9,000
$1.75
$5,200

$12,950 $15,750
5,200
5,200
$18,150 $20,950
====== ======

Variable Overhead Rate

Computed for each variable overhead cost pool
Activity measure should provide a logical
relationship between activity and cost
Direct labor hours, direct labor dollars, machine
hours, production orders, production-related physical
measures
Budgeted VOH cost for coming year
Budgeted activity measure for coming year

Fixed Overhead Rate

Select a specific activity level
Expected capacity
Theoretical capacity
Practical capacity
Normal capacity

Budgeted FOH cost for coming year

Budgeted activity measure for coming year

Disposition of Underapplied
and Overapplied Overhead
Year-end disposition depends on materiality of the amount.
If immaterial: amount closed to Cost of Goods Sold
Cost of Goods Sold increased if underapplied OH
Cost of Goods Sold decreased if overapplied OH
If material: amount allocated to
Work in Process Inventory
Finished Goods Inventory
Cost of Goods Sold

Combined Overhead Rate

Advantages
Clerical ease
Clerical cost savings
No formal requirement to separate overhead costs by
behavior

Continuing . . .
Combined Overhead Rate
Disadvantages
Reduces managers ability to determine the
causes of underapplied or overapplied overhead
Underlying cause-effect relationships between
activities and costs are blurred
Contributes to inability to reduce costs
Limits attempts to improve productivity
Hinders ability to plan operations, control costs, and
make decisions

Inventory Methods
Periodic
Inventory account
balances stay the same
throughout period
Inventory account adjusted
to new balance at end of
period

Perpetual
Inventory accounts are
adjusted as the product
flows through the company

Exhibit 4-15:
Purchase Materials
Raw Materials Inventory
Accounts Payable

85,000
85,000

To record cost of direct materials purchased on

account.

Exhibit 4-15:
Use Materials
Work in Process Inventory 69,000
Variable Factory Overhead 12,600
Raw Materials Inventory
81,600
To record direct materials transferred to production.

Exhibit 4-15:
Record Labor Costs
Work in Process Inventory
5,000
Variable Factory Overhead 13,800
Salaries and Wages Payable
18,800
To accrue factory wages for direct and indirect labor.

Exhibit 4-15:
Record Labor Costs
Fixed Factory Overhead
7,500
Salaries and Wages Payable
7,500
To accrue production supervisors salaries.

Exhibit 4-15:
Record Other Overhead
Variable Factory Overhead
Fixed Factory Overhead
Utilities Payable

1,200
670
1,870

To record mixed factory utility cost in its variable

and fixed proportions.

Exhibit 4-15:
Record Other Overhead
Fixed Factory Overhead
Cash

2,692
2,692

To record payments for contract maintenance for the

period.

Exhibit 4-15:
Record Other Overhead
Fixed Factory Overhead
8,333
Accumulated Depreciation
(Factory Equipment)
8,333
To record depreciation on factory assets for the
period.

Exhibit 4-15:
Record Other Overhead
Fixed Factory Overhead
Prepaid Factory Insurance

355
355

To record expiration of prepaid insurance on factory

assets.

Exhibit 4-15:
Apply Overhead
Work in Process Inventory 47,150
Variable Factory Overhead
27,600
Fixed Factory Overhead
19,550
To record the transfer of predetermined overhead
costs to Work in Process Inventory.

Exhibit 4-15:
Complete Product
Finished Goods Inventory 122,150
Work in Process Inventory
122,150
To record the transfer of work completed during the
period.

Exhibit 4-15:
Sell Product
Accounts Receivable
Sales

242,000
242,000

To record the sale of goods on account during the

period.

Exhibit 4-15:
Sell Product (Cost of Sales)
Cost of Goods Sold
119,958
Finished Goods Inventory
119,958
To record cost of goods sold for the period.

Least-Squares Regression
Determines cost formula of a mixed cost by
considering the best fit to ALL representative
data points
Finds y = ax + b
Uses multiple activity levels and related costs

Helps select the activity level that best predicts

total cost

Least-Squares Regression
The equations necessary to compute b and a values
using the method of least squares are as follows:

xy nxy
b = ------------- x2 nx2
a=

bx

Remember!
High-low and regression are cost
ESTIMATION techniques.
Appropriateness of cost formula
depends on validity of activity measure
chosen to predict the variable and
fixed costs.
When significant changes are
occurring, historical information may
not be useful in predicting future costs.