Fundamentals of Cost Accounting 6e

Fundamentals of

Cost Accounting

William N. Lanen

University of Michigan

Shannon W. Anderson

University of California at Davis

Michael W. Maher

University of California at Davis

Lan69479_fm_i-xxviii_1.indd 1 03/12/18 3:04 PM

FUNDAMENTALS OF COST ACCOUNTING, SIXTH EDITION

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Library of Congress Cataloging-in-Publication Data

Names: Lanen, William N., author. | Anderson, Shannon W., author. | Maher, Michael, 1946- author.

Title: Fundamentals of cost accounting / William N. Lanen, University of Michigan, Shannon W.

Anderson, University of California at Davis, Michael W. Maher, University of California at Davis.

Description: Sixth edition. | New York, NY : McGraw-Hill/Irwin, a business unit of The McGraw-Hill

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Identifiers: LCCN 2018048520 | ISBN 9781259969478 (alk. paper) | ISBN 1259969479 (alk. paper)

Subjects: LCSH: Cost accounting.

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Lan69479_fm_i-xxviii_1.indd 2 04/12/18 12:23 PM

iii

About the Authors

William N. Lanen

William Lanen is the KPMG Professor of Accounting Emeritus at theUniversity of

Michigan

. He previously taught at the Wharton School at the University of

Pennsylvania

. He received his AB from the University of California-Berkeley,

MS from Purdue University, and his PhD from the Wharton School. He has

taught cost accounting to undergraduates, MBA students, and executives, including

in global programs in Europe, South America, Australia, and Asia. He has also

served as the director of the Office of Action-Based Learning at the Ross School of

the University of Michigan. His research focuses primarily on performance evalua-

tion and reward systems.

Shannon W. Anderson

Shannon Anderson is the Michael and Joelle Hurlston Presidential Chair and

professor of management at the University of California-Davis. Previously she

taught at Rice University, the University of Melbourne, and the University of

Michigan

. She received her PhD from Harvard University and a BSE from

Princeton University. Shannon has taught undergraduate, masters, and doctoral

students a variety of courses on cost accounting, cost management, and management

control. Her research focuses on the design and implementation of performance

measurement and cost control systems.

Lan69479_fm_i-xxviii_1.indd 3 03/12/18 3:05 PM

Michael W. Maher

Michael Maher is a professor of management at the University of California-

Davis

. He previously taught at the University of Michigan and was a visiting

professor at the University of Chicago. He received his MBA and PhD from the

University of Washington and his BBA from Gonzaga University and was

awarded a CPA by the State of Washington. He has published more than a dozen

books, including several textbooks that have appeared in numerous editions. He has

taught at all levels from undergraduate to MBA to PhD and executives. His research

focuses on cost analysis in service organizations, corporate governance, and white-

collar crime. In 2015, he received a Lifetime Achievement Award for his research

and teaching in managerial accounting from the AICPA and the AAA.

Dedication

To my wife, Donna, and my children, Cathy and Tom, for

encouragement, support, patience, and general good cheer

throughout the years.

Bill

I dedicate this book to the extraordinary public school

teachers and counselors who shaped my early development

and modeled excellence in teaching, especially Don Bryant,

Michael Varner, Carolyn Crouse, and Lee Martin; and to the

teachers who had the first and most enduring influence on

me, my parents, Max and Nina Weems.

Shannon

I dedicate this book to my wife, Kathleen; my children,

Krista and Andrea; my stepchildren, Andrew and Emily;

and to my extended family, friends, and colleagues who

have provided their support and wisdom over the years.

Michael

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Step into the Real World

LO 5-10 (Appendix B) Understand the mathematical relationship describing

learning phenomenon.

©Halfpoint/Getty Images

Chapter Five

Cost Estimation

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

LO 5-1 Understand the reasons for estimating ﬁxed and variable costs.

LO 5-2 Estimate costs using engineering estimates.

LO 5-3 Estimate costs using account analysis.

LO 5-4 Estimate costs using statistical analysis.

LO 5-5 Interpret the results of regression output.

LO 5-6 Identify potential problems with regression data.

LO 5-7 Incorporate the eects of learning when estimating costs.

LO 5-8 Evaluate the advantages and disadvantages of alternative cost

estimation methods.

LO 5-9 (Appendix A) Use Microsoft Excel to perform a regression analysis.

the

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177

The Decision

I’ve read several books on cost analysis and worked

through decision analysis problems in some of the col-

lege classes I am taking in the evening. I own my own

business and I realize that there is one important thing

that we always take for granted in doing those prob-

lems. We are always given the data. Now I know that

doing the analysis once you have the data is the easier

part. But once I have the data, there are still questions

I want to answer. How are the costs determined? How

do I know if they are ﬁxed or variable?

For example, I thought about the importance of

being able to determine ﬁxed and variable costs after

reading an article about selling goods through dierent

sales channels. [see the Business Application item

“Understanding Fixed and Variable Costs for Online

Sales”]. The article talked about the importance of

understanding the ﬁxed as well as variable costs when

you sell both through online and in-store channels.

Although I am in a dierent industry, the basic princi-

ples still apply. I am thinking about expanding locations

(or what we call "renovation centers") and a key factor

in the analysis is the additional ﬁxed costs I will incur

when I open a new one. I need to make sure I can gen-

erate enough business to cover them.

Joseph Kim owns JK Renovations, a network of home renova-

tion centers located throughout the West. Joseph is thinking

about opening a new center and has asked you to help him

make a decision. He especially wants your help estimating

the costs to use in the analysis.

Why Estimate Costs?

When managers make decisions, they need to compare the costs (and benefits) among

alternative actions. Therefore, managers need to estimate the costs associated with each

alternative. We saw in Chapter 4 that good decisions require good information about

costs; the better these estimates, the better the decision managers will make. In this

chapter, we discuss how to estimate the cost data required for decision making. Cost

estimates can be an important element in helping managers make decisions that add

value to the company.

Basic Cost Behavior Patterns

LO 5-1

Understand the reasons

for estimating ﬁxed and

variable costs.

The most important characteristic of costs for decision making is how they behave—

how they vary with activity is the key distinction for decision making. Therefore, the

basic idea in cost estimation is to estimate the relation between costs and the variables

affecting costs, the cost drivers. We focus on the relation between costs and one impor-

tant variable that affects them—activity level. Activities can be measured by volume

(for example, units of output, machine-hours, pages typed, miles driven), by complex-

ity (for example, number of different products, number of components in a product), or

by any other cost driver.

You already know the key terms for describing cost behavior: variable costs and

fixed costs. You also know that variable costs change proportionately with activity levels

but fixed costs do not. Building on that, the formula that we use to estimate costs is the

familiar cost equation:

TC = F + VX

where TC refers to total costs, F refers to fixed costs that do not vary with activity levels,

V refers to variable costs per unit of activity, and X refers to the volume of the activity.

In practice, we usually have data about the total costs incurred at each of the vari-

ous activity levels, but we do not have a breakdown of costs into fixed and variable

components because accounting records typically accumulate costs by account, not by

behavior. What we need to do is to use the information from the accounts to estimate

cost behavior.

Lan69479_ch05_176-225.indd 177 13/11/18 2:51 PM

178 Part II Cost Analysis and Estimation

What Methods Are Used to Estimate Cost Behavior?

Chapter Opening Vignettes

Do your students sometimes wonder how the course

connects with their future? Each chapter opens with The

Decision, a vignette in which a decision maker needs cost

accounting information to make a better decision. This sets

the stage for the rest of the chapter and encourages stu-

dents to think of concepts in a business context.

Understanding Fixed and Variable Costs for Online Sales

There is a common belief that online sales are more proﬁt-

able than sales at retail locations. However, encouraging cus-

tomers to buy online while continuing to operate a store is

not a guarantee of higher proﬁtability. If customers visit a

showroom to see the product, but then buy online, then the

ﬁrm has extra costs (shipping and running the website) as

compared to running a store but no new sources of revenue.

Indeed, it may be appropriate to allocate costs of running the

store to the online sales if customers only buy after visiting

the store.

A manager considering expanding online sales must eval-

uate whether the new channel of distribution brings in new

customers who may not be able to visit the store. If not, accord-

ing to one expert:

... a look at the nuances of ﬁxed and variable costs

suggests retailers doing both should prefer sales on the

shop ﬂoor.

The reason is that a retailer selling through both channels

has to ensure that the ﬁxed costs of operating the store aren’t

oset by increased ﬁxed costs of operating a virtual storefront

and variable costs of shipping. Doing this analysis requires the

manager to have a good understanding of the variable and

ﬁxed costs of each channel as well as the customers who are

attracted to each channel.

Source:“Overheard: Magic Bullet Misses the Mark” The Wall Street

Journal, November 27, 2014.

Business Application

We will study three general methods to estimate the relation between cost behavior and

activity levels that are commonly used in practice:

∙

Engineering estimates.

∙

Account analysis.

∙

Statistical methods, such as regression analysis.

Results are likely to differ from method to method. Consequently, it is a good idea to use

more than one method so that results can be compared. Large differences in cost esti-

mates suggest it is worthwhile to conduct additional analysis. If the estimates are similar,

you may have more confidence in them. In practice, operating managers frequently apply

their own best judgment as a final step in the estimation process. They often modify the

estimate submitted by the controller’s staff because they have more knowledge of the

process and, more important, they bear ultimate responsibility for all cost estimates.

These methods, therefore, should be seen as ways to help management arrive at the best

estimates possible. Their weaknesses as well as their strengths require attention.

Engineering Method

How might you begin to help Joseph estimate the cost of a new renovation center? One

approach is to start with a detailed step-by-step analysis of what needs to be done, that is,

the activities the staff would conduct to operate the center. Probably the first thing you

would want to know is the size of the center. Because this is a service firm, the size can

be easily represented by the time it takes employees to provide renovation services (labor-

hours). Joseph estimates that the new center will average about 960 labor-hours monthly.

Once you determine the size of the center, you can turn to the other necessary

activities. Examples might be renting the office where the administrative work will

take place, using lights and other utilities, providing support, or using supplies such as

gloves and screws. You would then estimate the times or costs for each of these activi-

ties. The times required for each step requiring labor (billing support, for example)

would be multiplied by an estimated wage rate. Other costs, such as licensing fees and

so on, would be estimated from local market information. The estimate you just made

is an engineering estimate.

LO 5-2

Estimate costs using

engineering estimates.

engineering estimate

Cost estimate based on

measurement and pricing of

the work involved in a task.

Lan69479_ch05_176-225.indd 178 13/11/18 2:51 PM

Business Application

Do your students need help connecting theory

to application? The Business Application

examples tie in to The Decision chapter-

opening vignettes and are drawn from

contemporary journals and the authors’ own

experiences. They illustrate how to apply cost

accounting methods and tools.

“[The Business Application features are] a very helpful

piece to help students see how the course material

becomes relevant in the professional world.”

—N. Ahadiat

University of California Pomona

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Debrief

Do your students understand how

to apply the concepts in each

chapter to become better decision

makers? All chapters end with a

Debrief feature that links the top-

ics in the chapter to the decision

problem faced by the manager in

the opening vignette.

196 Part II Cost Analysis and Estimation

The Debrief

After considering the cost estimates in Exhibit 5.8, Joseph Kim

commented:

This exercise has been very useful for me. First, I

learned about dierent approaches to estimating the

cost of a new center. More important, I learned about the

advantages and disadvantages of each approach.

When I look at the numbers in Exhibit 5.8, I have

conﬁdence in my decision to open a new center.

Although there is a range in the estimates, all of the esti-

mates are below my expected revenues. This means I

am not going to spend more time on reconciling the cost

estimates because I know that regardless of which esti-

mate I think is best, my decision will be the same.

Accurate cost estimation is important to most organizations for decision-making purposes.

Although no estimation method is completely accurate, some are better than others. The usefulness

of a cost estimation method depends to a great extent on the user’s knowledge of the business and

the costs being analyzed.

The following summarizes the key ideas tied to the chapter’s learning objectives.

LO 5-1 Understand the reasons for estimating fixed and variable costs. The behavior of

costs, not the accounting classification, is the important distinction for decision

making. Cost estimation focuses on identifying (estimating) the fixed and variable

components of costs.

LO 5-2 Estimate costs using engineering estimates. Cost estimates can be developed by identi-

fying all activities and resources required to make a product or provide a service. An engi-

neering cost estimate applies unit costs to the estimate of the physical resources required

to accomplish a task.

LO 5-3 Estimate costs using account analysis. Reviewing historical accounting data

to determine the behavior of costs requires analyzing the accounts. Because

these estimates are based on actual results, they include factors such as down-

time for maintenance and absenteeism that could be missed by an engineering

estimate.

LO 5-4 Estimate costs using statistical analysis. Statistical analysis of data allows

estimates of costs to be based on many periods of operation. Statistical estimates

average out fluctuations in the relation between costs and activities. Scattergraphs

provide a visual representation of the relation and are useful to see how closely

costs and activities are related. High-low analysis uses two observations to estimate

the slope of the line (an estimate of the unit variable cost) and the intercept (an

estimate of the fixed costs). Regression analysis uses all data and can be

accomplished easily with a spreadsheet program. Using regression analysis avoids

the problem of selecting observations in the high-low method that might not be

representative.

LO 5-5 Interpret the results of regression output. Using regression analysis requires care

because the estimates depend on certain assumptions. At a minimum, you should look at a

scattergraph to determine whether the relation appears to be representative for your data.

You should also check the coefficient of determination (R

) to determine how closely the

estimates fit the observed data.

LO 5-6 Identify potential problems with regression data. Regression methods rely on

certain assumptions. The relation between cost and activity is assumed to be linear,

but this might not be the case, especially outside the relevant range. In using data

from actual operations, it is important to ensure that each observation is representa-

tive and that there have been no special circumstances (strikes, weather disasters, etc.)

SUMMARY

Lan69479_ch05_176-225.indd 196 13/11/18 2:52 PM

“Good illustrations and real-world examples. It has

broad and comprehensive topic coverage.”

—Robert Lin

California State University East Bay

Chapter 5 Cost Estimation 205

All applicable Exercises are included in Connect. EXERCISES

costs would appear to be below budget. The apparent error could affect regression analysis

because you are using both December and January in your analysis. Should you report your

concerns about the way maintenance costs have been recorded? If so, to whom would you

report your concerns?

5-23. Give at least three applications of the learning phenomenon that were not mentioned in the

text.

5-24. Are learning curves likely to affect materials costs per unit? Explain.

5-25. McDonald’s, the fast-food restaurant, is known for high employee turnover, high quality,

and low costs. Using your knowledge of the learning phenomenon, how does McDonald’s

get high quality and low costs when it has so much employee turnover?

5-26. Apple Inc. is developing a new product (the iWhatever). Managers at Apple are interested

in estimating the impact of learning on the cost of producing the iWhatever. They plan to

use data from previous products, such as the iPod and the iPad, to estimate the learning

parameter. What are the advantages of doing this? What are the disadvantages?

5-27. A manager asks you for a cost estimate to open a new retail outlet and says, “I want you to

How might use statistical analysis, so it will be based on real data and therefore objective.”

you respond?

5-28. Refer t

o the Business Application, “Understanding Fixed and Variable Costs for Online

Sales.” Consider a bank that offers both online and branch access for customers. Based on

the costs of service, the bank has decided it should motivate customers to use online ser-

vices in place of branch services. After several months, they have persuaded over

50 percent of their customers to use the online service for most of their business. However,

with the latest profit report, it appears that the bank is actually making lower profits than

before. Why might that be?

5-29. Methods of Estimating Costs: Engineering Estimates

Custom Homebuilders (CH) designs and constructs high-end homes on large lots owned by

customers. CH has developed several formulas, which it uses to quote jobs. These include

costs for materials, labor, and other costs. These estimates are also dependent on the region of

the country a particular customer lives. The following are the cost estimates for one region in

the Midwest.

Administrative costs.................................. $,

Building costs – per square foot (basic)................. $    

Building costs – per square foot (moderate)............. $   

Building costs – per square foot (luxury) ................ $   

Appliances (basic) ................................... $,

Appliances (moderate) ............................... $,

Appliances (luxury)................................... $,

Utilities costs (if required) ............................. $,

Required

A customer has expressed interest in having CH build a moderate, 3,000-square-foot home on a

vacant lot, which does not have utilities. Based on the engineering estimates above, what will such

a house cost to build?

5-30. Methods of Estimating Costs: Engineering Estimates

Refer to the information in Exercise 5-29.

Required

A customer has asked CH for an estimate on a basic, 1,500-square-foot on a vacant lot, which

already has utilities installed. The client is a cooking enthusiast, and also wants luxury appli-

ances. Based on the engineering estimates in the previous exercise, what will such a house cost

to build?

(LO 5-2)

Lan69479_ch05_176-225.indd 205 13/11/18 2:52 PM

End-of-Chapter Material

Being able to assign end-of-chapter

material with confidence is important.

The authors have tested the end-of-

chapter material over time to ensure

quality and consistency with the chap-

ter content. In the sixth edition the

authors have updated several exercises

and added several new questions.

“This is an excellent cost accounting book with quality

end of chapter materials.”

—Judy Daulton

Piedmont Technical College

“Well written; good end-of-chapter material.”

—R. E. Bryson

University of Alabama in Huntsville

Lan69479_fm_i-xxviii_1.indd 6 03/12/18 3:05 PM

vii

Using Excel in the Classroom

Excel

is essential in today’s business envi-

ronment, and Lanen,6e integrates Excel

where appropriate in the text. Several exer-

cises and problems in each chapter can be

solved using Excel spreadsheets tem-

plates.An Excel logo appears in the text

next to these problems. Additionally, com-

mencing with the sixth edition many of

these exercises are now algorithmically gen-

erated and assignable in Connect, with scor-

ing of select inputs for gradebook inclusion.

NEW! Excel Simulationsare auto-graded

in Connect and allow students to practice

their Excel skills, such as basic formulas

and formatting, within the context of

accounting in a simulated Excel environ-

ment. When enabled by the instructor, these

questions feature animated, narrated Help

and Show Me tutorials.

“Strong end of chapter and test bank materials. Strong

inclusion of Excel in the chapters”

—Michael Flores,

Wichita State University

Integrative Cases

Cases can generate classroom discussion

or be the basis for good team projects.

These integrative cases, which rely on

cost accounting principles from pr evious

chapters as well as the current chapter,

ask students to apply the different

techniques they have learned to a

realistic situation.

224 Part II Cost Analysis and Estimation

Overhead and administrative costs are not affected by producing this tool.

The current purchase price is $100,000 per unit, so the report recommends that Krylon con-

tinue to purchase the product from CO., Inc.

Required

Assume that Krylon could experience labor-cost improvements on the tool production consistent

with an 80 percent learning curve. Should Krylon produce or purchase its annual requirement of

eight tools? Explain your answer. (Note that the 80 percent learning rate coefficient is −0.3219.)

(CMA adapted)

INTEGRATIVE CASE

5-72. Cost Estimation, CVP Analysis, and Decision Making

Luke Corporation produces a variety of products, each within their own division. Last year, the

managers at Luke developed and began marketing a new chewing gum, Bubbs, to sell in vending

machines. The product, which sells for $5.25 per case, has not had the market success that manag-

ers expected, and the company is considering dropping Bubbs.

The product-line income statement for the past 12 months follows.

Revenue ........................... $14,682,150

Costs

Manufacturing costs............... $14,440,395

Allocated corporate costs (@5%) .... 734,108  15,174,503

Product-line margin ................. $  (492,353)

Allowance for tax (@20%) ............      98,470

Product-line proﬁt (loss).............. $  (393,883

)

All products at Luke receive an allocation of corporate overhead costs, which is computed as

5 percent of product revenue. The 5 percent rate is computed based on the most recent year’s

corporate cost as a percentage of revenue. Data on corporate costs and revenues for the past two

years follow.

Corporate Revenue Corporate Overhead Costs

Most recent year ..... $106,750,000 $ 5,337,500

Previous year . . . . . . . . $ 76,200,000  4,221,000

Roy O. Andre, the product manager for Bubbs, is concerned about whether the product will be

dropped by the company and has employed you as a financial consultant to help with some analy-

sis. In addition to the information given, Mr. Andre provides you with the following data on prod-

uct costs for Bubbs.

Month Cases Production Costs

1 ............. 207,000 $1,139,828

2 ............. 217,200 1,161,328

3 ............. 214,800 1,169,981

4 ............. 228,000 1,185,523

5 ............. 224,400 1,187,827

6 ............. 237,000 1,208,673

7 ............. 220,200 1,183,699

8 ............. 247,200 1,226,774

9 ............. 238,800 1,225,226

10 ............. 252,600 1,237,325

11 ............. 250,200 1,241,760

12 ............. 259,200 1,272,451

(LO 5-4, 5, 9)

Lan69479_ch05_176-225.indd 224 13/11/18 2:52 PM

Chapter 5 Cost Estimation 217

The controller’s office estimated overhead costs at $3,600 for fixed costs and $18 per unit for

variable costs. Your colleague, Lance, who graduated from a rival school, has already done the

analysis and reports the “correct” cost equation as follows:

Overhead = $10,600 + $16.05per unit

Lance also reports that the correlation coefficient for the regression is .82 and says, “With 82

percent of the variation in overhead explained by the equation, it certainly should be adopted as the

best basis for estimating costs.”

When asked for the data used to generate the regression, Lance produces the following:

Month Overhead Unit Production

 .............. $, ,

 .............. , ,

 .............. , ,

 .............. , ,

 .............. , ,

 .............. , ,

 .............. , ,

 .............. , ,

 .............. , ,

 .............. , ,

 .............. , ,

 .............. , ,

 .............. , ,

The company controller is somewhat surprised that the cost estimates are so different. You have

therefore been assigned to check Lance’s equation. You accept the assignment with glee.

Required

Analyze Lance’s results and state your reasons for supporting or rejecting his cost equation.

5-62. Interpretation of Regression Results: Multiple Choice

The Business School at Eastern College is collecting data as a first step in the preparation of

next year’s budget. One cost that is being looked at closely is administrative staff as a function

of student credit hours. Data on administrative costs and credit hours for the most recent

13 months follow.

Month Administrative Costs Credit Hours

July .......... $ , 

August ....... , 

September.... , ,

October ...... , ,

November .... ,, ,

December .... , ,

January....... , ,

February...... ,, ,

March ........ , ,

April.......... , ,

May .......... ,, ,

June ......... , 

July .......... , 

Total ....... $,, ,

Average ...... $ ,

,

The controller’s office has analyzed the data and given you the results from the regression analysis,

as follows.

(LO 5-5)

Lan69479_ch05_176-225.indd 217 13/11/18 2:52 PM

216 Part II Cost Analysis and Estimation

Required

a. Draw a scattergraph relating overhead costs to the number of units.

b. Using the high-low method, estimate overhead costs for a month when output is expected to

be 120,000 units.

5-60. Interpretation of Regression Results: Simple Regression Using a Spreadsheet

Hartman Company’s Lucas plant manufactures thermostatic controls. Plant management has

experienced fluctuating monthly overhead costs and wants to estimate overhead costs accu-

rately to plan its operations and its financial needs. Interviews with plant personnel and studies

reported in trade publications suggest that overhead in this industry tends to vary with labor-

hours.

A member of the controller’s staff proposed that the behavior pattern of these overhead

costs be determined to improve cost estimation. Another staff member suggested that a good

starting place for determining cost behavior patterns is to analyze historical data. Following

this suggestion, monthly data were gathered on labor-hours and overhead costs for the past two

years. No major changes in operations occurred over this period of time. The data are shown in

the following table.

Month Labor-Hours Overhead Costs

1 251,563 $2,741,204

2 238,438 2,166,231

3 192,500 1,902,236

4 271,250 2,590,765

5 323,750 3,071,812

6 290,938 2,618,161

7 271,250 2,480,231

8 251,563 2,745,558

9 231,875 2,211,799

10 343,438 3,437,704

11 185,938 2,314,436

12 231,875 2,550,630

13 382,813 3,603,709

14 376,250 3,404,786

15 290,938 3,016,493

16 395,938 3,638,331

17 356,563 3,553,886

18 323,750 3,191,617

19 389,375 3,481,714

20 317,188 3,219,519

21 343,438 3,495,424

22 336,875 3,207,258

23 382,813 3,600,622

24 376,250 3,736,658

Required

a. Use the high-low estimation method to estimate the overhead cost behavior (fixed and vari-

able portions components of cost) for the Lucas plant.

b. Prepare a scattergraph showing the overhead costs plotted against the labor-hours.

c. Use a spreadsheet program to compute regression coefficients to describe the overhead cost

equation.

d. Use the results of your regression analysis to develop an estimate of overhead costs assuming

350,000 labor-hours will be worked next month.

5-61. Interpretation of Regression Results: Simple Regression

Your company is preparing an estimate of its production costs for the coming period. The control-

ler estimates that direct materials costs are $45 per unit and that direct labor costs are $21 per hour.

Estimating overhead, which is applied on the basis of direct labor costs, is difficult.

(LO 5-4, 5, 9)

(LO 5-4, 5)

Lan69479_ch05_176-225.indd 216 13/11/18 2:52 PM

Lan69479_fm_i-xxviii_1.indd 7 03/12/18 3:05 PM

viii

What’s New in

the Sixth Edition?

Our primary goal in the sixth edition remains the same as in the previous five editions––to

offer a cost accounting text that lets the student see the development of cost accounting tools

and techniques as a natural response to decision making. We emphasize the intuition behind

concepts and work to minimize the need to “memorize.” We believe that students who develop

this intuition will, first, develop an appreciation of what cost accounting is about and, second,

will have an easier time understanding new developments that arise during their careers. Each

chapter clearly establishes learning objectives, highlights numerous real-world examples, and

identifies where ethical issues arise and how to think about these issues. Each chapter includes

at least one integrative case that illustrates the links among the topics.

We present the material from the perspective of both the preparer of information as well as

those who will use the information. We do this so that both accounting majors and those stu-

dents planning other careers will appreciate the issues in preparing and using the information.

The opening vignettes tie to one of the Business Application features in the chapter to high-

light the relevance of cost accounting to today’s business problems. All chapters end with a

Debrief that links the topics in the chapter to the decision problem faced by the manager in the

opening vignette.

The end-of-chapter material has increased by 9 to 16 percent, depending on the chapter, and

12 percent overall. Throughout the revision process, we have retained the clear writing style

that is frequently cited as a strength of the text.

1 Cost Accounting: Information for

Decision Making

∙

New opening vignette.

∙

Four new Business Applications.

∙

Updated link for IMA Ethics.

∙

Updated discussion and examples on

Trends in Cost Accounting.

∙

Two new exercises.

∙

Four new problems.

2 Cost Concepts and Behavior

∙

New opening vignette.

∙

Two newBusiness Applications.

∙

Four new exercises.

∙

Four new problems.

3 Fundamentals of Cost-Volume-Profit

Analysis

∙

New opening vignette.

∙

One new Business Application.

∙

One new critical discussion question.

∙

Four new exercises.

∙

Three new problems.

4 Fundamentals of Cost Analysis for

Decision Making

∙

New opening vignette.

∙

Two new Business Applications.

∙

One new critical discussion question.

∙

Ten new problems.

5 Cost Estimation

∙

New opening vignette.

∙

One new Business Application.

∙

Added Learning Objective for learning

curves (using existing material).

∙

One new critical discussion question.

∙

Three new exercises.

∙

Four new problems.

6 Fundamentals of Product and

Service Costing

∙

New opening vignette.

∙

One new Business Application.

∙

Six new exercises.

∙

Two new problems.

Lan69479_fm_i-xxviii_1.indd 8 03/12/18 3:05 PM

7 Job Costing

∙

New opening vignette.

∙

One new Business Application.

∙

Two new exercises.

∙

Four new problems.

8 Process Costing

∙

New opening vignette.

∙

Five new exercises.

∙

Three new problems.

9 Activity-Based Costing

∙

New opening vignette.

∙

One new Business Application.

∙

Two new critical discussion questions.

∙

Four new exercises.

∙

Two new problems.

10 Fundamentals of Cost Management

∙

New opening vignette.

∙

One new Business Application.

∙

One new critical discussion question.

∙

Three new exercises.

∙

Two new problems.

11 Service Department and Joint

Cost Allocation

∙

New opening vignette.

∙

One new critical discussion question.

∙

Five new exercises.

∙

Two new problems.

12 Fundamentals of Management

Control Systems

∙

New opening vignette.

∙

Two new Business Applications.

∙

Three new exercises.

∙

Two new problems.

13 Planning and Budgeting

∙

New opening vignette.

∙

Four new exercises.

∙

Two new problems.

∙

One new integrative case.

14 Business Unit Performance

Measurement

∙

New opening vignette.

∙

One new Business Application.

∙

Three new exercises.

∙

Three new problems.

15 Transfer Pricing

∙

New opening vignette.

∙

One newBusiness Application.

∙

Four new exercises.

∙

Two new problems.

16 Fundamentals of Variance Analysis

∙

New opening vignette.

∙

Five new exercises.

∙

Three new problems.

Additional Topics in

Variance Analysis

∙

New opening vignette.

∙

Four new exercises.

∙

Four new problems.

18 Performance Measurement to

Support Business Strategy

∙

New opening vignette.

∙

Three new Business Applications.

∙

Four new exercises.

∙

Two new problems.

Appendix Capital Investment Decisions:

An Overview

∙

One new exercise.

∙

One new problem.

Lan69479_fm_i-xxviii_1.indd 9 03/12/18 3:05 PM

Students—study more eciently, retain

more and achieve better outcomes.

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Eective, ecient studying.

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xii

Acknowledgments

A special thank you

To the following individuals who helped develop and cri-

tique the ancillary package: Patti Lopez for accuracy

checking the manuscript and solutions manual; William

Lyle for preparing the instructor’s manual and PowerPoint

slides; Helen Roybark for accuracy checking the instruc-

tor’s manual and PowerPoint; Stacie Hughes for updating

the test bank; and Janice Fergusson for accuracy checking

the test bank.

We are grateful for the outstanding support of McGraw-

Hill. In particular, we would like to thank Tim Vertovec,

Managing Director, Accounting and Business Law;

Elizabeth Eisenhart, Portfolio Manager; Rose Koos,

Director, Product Development; Michele Janicek, Lead

Product Developer; Marilyn Isaacks and Julie Hankins,

Product Developers; Kevin Moran, Associate Director

of Digital Content; Xin Lin, Digital Product Analyst;

Sarah Sacco, Editorial Coordinator; Katherine Wheeler,

Marketing Manager; Natalie King, Director of

Marketing; Fran Simon and Brian Nacik, Content

Project Managers; Karen Jozefowicz, TS Content

Project Manager; Susan Culbertson, Buyer; Melissa

Homer, Content Licensing Specialist; and Matt

Diamond, Designer.

We also want to recognize the valuable input of all those

dedicated instructors who helped guide our editorial and

pedagogical decisions:

Editorial Board, Sixth Edition

Michael Alles, Rutgers University

Linda Bressler, University of Houston

Robert Cabral, Oxnard College

Don Campbell, Brigham Young University–Idaho

Joseph Cunningham, Albright College

Alan Czyzewski, Indiana State University

Sebahattin Demirkan, University of Maryland

Karen Congo Farmer, Texas A&M

Marina Grau, Houston Community College

Stacie Hughes, Athens State University

Cynthia Khanlarian, North Carolina Agricultural and

Technical State University

Jason Lee, State University of New York–Plattsburgh

Ashley Minnich, William Jewell College

Patrick Nguyen, San Jacinto College–Central Campus

Michael Nickla, Ivy Tech Community College

Baseemah Nance, Central Piedmont Community College

Rama Ramamurthy, Georgetown University

Emily Vera, University of Colorado–Denver

Editorial Board, Fifth Edition

Kreag Danvers, Clarion University

Melanie Hicks, Liberty University

Bob Holtfreter, Central Washington University

Larry N. Killough, Virginia Polytechnic Institute

Harrison Liu, The University of Texas at San Antonio

Pam Meyer, University of Louisiana at Lafayette

Clayton Sager, University of Wisconsin–Whitewater

Diane Tanner, University of North Florida

Emily Vera, University of Colorado–Denver

Editorial Board, Fourth Edition

N. Ahadiat, University of California Pomona

Rowland Atiase, McCombs School of Business University

of Texas

R. E. Bryson, University of Alabama in Huntsville

David Bukovinsky, Wright State University

Maureen Butler, University of Tampa

Donald Campbell, Brigham Young University–Idaho

Chak-Tong Chau, University of Houston Downtown

Judy Daulton, Piedmont Technical College

Jennifer Dosch, Metropolitan State University

Robert Elmore, Tennessee Technological University

Karen Congo Farmer, Texas A&M University

Budd Fennema, Florida State University

Michael Flores, Wichita State University

Ronald Guymon, Georgia State University

Lan69479_fm_i-xxviii_1.indd 12 03/12/18 3:05 PM

xiii

Michael Hammond, Missouri State University

Betty Harper, Middle Tennessee State University

Jay Holmen, University of Wisconsin–Eau Claire

Raymond Johnson, Guilford College

George Joseph, University of Massachusetts Lowell

Leslie Kren, University of Wisconsin–Milwaukee

Robert Lin, California State University, East Bay

Yoshie Saito Lord, Eastern Illinois University

Lorraine Magrath, Troy University

Malllory McWilliams, San Jose State University

Jimmy Mistry, Suffolk University

Edward Monsour, CSULA

Muroki Mwaura, William Patterson University

Linda Schain, Hofstra University

Lynne Shoaf, Belmont Abbey College

Kenneth Sinclair, Lehigh University

Lynn Suberly, University of South Alabama

Stephen West, Arizona State University

Wallace Wood, University of Cincinnati

Nan Zhou, State University of New York at Binghamton

Editorial Board, Third Edition

Vidya Awasthi, Seattle University

Molly Brown, James Madison University

Gia Chevis, Baylor University

Michele Chwastiak, University of New Mexico

Darlene Coarts, University of Northern Iowa

Janice Cobb, Texas Christian University

Cheryl Corke, Genesee Community College

Steven Daulton, Piedmont Technical College

Joe Dowd, Eastern Washington University

Rafik Elias, California State University, Los Angeles

Sheri Erickson, Minnesota State University Moorhead

Michael Flores, Wichita State University

Patrick Flynn, Baldwin-Wallace College

Bob Hartman, University of Iowa

Daniel Hinchliffe, University of North

Carolina–Asheville

Jay Holmen, University of Wisconsin–Eau Claire

Bob Holtfreter, Central Washington University

Curtis Howell, Georgia Southwestern State University

Norma Hunting, Chabot College

Fred Jacobs, Michigan State University

Douglas Johnson, Southeast Community College

Larry Killough, Virginia Polytechnic Institute

Leslie Kren, University of Wisconsin–Milwaukee

Edward Lance Monsour, California State University,

Los Angeles

Cheryl Mckay, Monroe County Community College

Pam Meyer, University of Louisiana at Lafayette

Lorie Milam, University of Northern Colorado

Daniel O’Brien, North Central Technical College

Michael Petersen, Arizona State University

Mina Pizzini, Southern Methodist University

Shirley Polejewski, University of Saint Thomas

Paul Sheldon Foote, California State University, Fullerton

Lynn Suberly, University of South Alabama

Kim Tan, California State University, Stanislaus

Benson Wier, Virginia Commonwealth University

David Wiest, Merrimack College

Christine Wilkinson, Iowa State University

Wallace Wood, University of Cincinnati

Nan Zhou, State University of New York

Editorial Board, Second Edition

Gary Adna Ames, Brigham Young University–Idaho

Nas Ahadiat, California State Polytechnic University, Pomona

Sepeedeh Ahadiat, California State Polytechnic University,

Pomona

Michael Alles, Rutgers University

Felix Amenkhienan, Radford University

Kashi Balachandran, New York University

Daniel Bayak, Northampton Community College

Joseph Berry, Campbell University

Charles Betts, Delaware Technical and Community College

Michael Blackett, National American University

Marvin Bouillon, Iowa State University

Michelle Cannon, Ivy Tech Community College

Roberta Cable, Pace University

Chiaho Chang, Montclair State University

Bea Chiang, The College of New Jersey

D. Douglas Clinton, Northern Illinois University

Carlos Colon, Valencia Community College

Joan Cook, Milwaukee Area Tech College

Sue Cullers, Tarleton State University

Alan Czyzewski, Indiana State University

Lee Daugherty, Lorain County Community College

Fara Elikai, University of North Carolina–Wilmington

Terry Elliott, Morehead State University

Robert Elmore, Tennessee Tech University

Timothy Farmer, University of Missouri–St. Louis

Michael Fedoryshyn, St. John Fisher College

Lan69479_fm_i-xxviii_1.indd 13 03/12/18 3:05 PM

xiv

Jerry Ferry, University of North Alabama

Benjamin Foster, University of Louisville

Kenneth Fowler, Santa Clara University

John Garlick, Fayetteville State University

Lisa Gillespie, Loyola University, Chicago

Lorraine Glasscock, University of North Alabama

Sylwia Gornik-Tomaszewski, St. John’s University

Marina Grau, Houston Community College

Mary Green, University of Virginia

Ralph Greenberg, Temple University

Robert Gruber, University of Wisconsin–Whitewater

Aundrea Kay Guess, St. Edward’s University

Sanjay Gupta, Valdosta State University

Michael R. Hammond, Missouri State University

Betty Harper, Middle Tennessee State University

Jeannie Harrington, Middle Tennessee State University

Geoffrey Heriot, Greenville Technical College

Aleecia Hibbets, University of Louisiana–Monroe

Jonathan Hidalgo, Montclair University

Jay Holmen, University of Wisconsin–Eau Claire

Bob Holtfreter, Central Washington University

Bikki Jaggi, Rutgers University

Agatha Jeffers, Montclair State University

Thomas Kam, Hawaii Pacific University

Larry Killough, Virginia Polytechnic University

Mehmet Kocakulah, University of Southern Indiana

Thomas Krissek, Northeastern Illinois University

Daniel Law, Gonzaga University

Minwoo Lee, Western Kentucky University

Joan Luft, Michigan State University

Janet Mabon, University of Oregon

Suneel Maheshwari, Marshall University

Linda Mallory, Central Virginia Community College

Mark Martinelli, De Anza College

Maureen Mascha, Marquette University

Raj Mashruwala, Washington University, St. Louis

Michele Matherly, University of North Carolina at Charlotte

Barbara Mcelroy, Susquehanna University

Gloria McVay, Winona State University

Pam Meyer, University of Louisiana–Lafayette

David Morris, North Georgia College

Ann Murphy, Metropolitan State College of Denver

Rosemary Nurre, College of San Mateo

Carolyn Ogden, University of Massachusetts, Boston

Tamara Phelan, Northern Illinois University

Cynthia Phipps, Lake Land College

Jo Ann Pinto, Montclair State University

Paul Polinski, Case Western Reserve University

Judy Ramage, Christian Brothers University

Roy Regel, University of Montana–Missoula

David Remmele, University of Wisconsin–Whitewater

Gerald Rosson, Lynchburg College

David Satava, University of Houston

Kathy Sauer, Aakers Business College

Richard Sauoma, University of California, Los Angeles

Margaret Shackell-Dowell, University of Notre Dame

Karen Shastri, University of Pittsburgh

Donald Simmons, Frostburg State University

Kenneth Sinclair, Lehigh University

James Smith, Saint Cloud State University

Toni Smith, University of New Hampshire

Carol Springer, Georgia State University

Scott Steinkamp, College of Lake County

Dennis Stovall, Grand Valley University

Ronald Stunda, Birmingham-Southern College

Norman Sunderman, Angelo State University

Kim Tan, California State University–Stanislaus

James Thompson, Oklahoma City University

Robin Turner, Rowan-Cabarrus Community College

Michael Tyler, Barry University

Karen Varnell, Tarleton State University

Stephen Wehner, Columbia College

Randi Whitney, University of Oregon

Michael Wilson, Metropolitan State University

Priscilla Wisner, Montana State University

Raymond Zingsheim, Moraine Park Technical University

Editorial Board, First Edition

Rowland Atiase, University of Texas at Austin

Timothy B. Biggart, University of North Carolina

Rodger Brannan, University of Minnesota at Duluth

Wayne Bremser, Villanova University

Chiaho Chang, Montclair State University

Kerry Colton, Aims Community College

William Cready, Louisiana State University

Patricia Derrick, George Washington University

Robert Elmore, Tennessee Tech University

John Giles, North Carolina State University

Penelope Sue Greenberg, Widener University

Jeannie Harrington, Middle Tennessee State University

Lan69479_fm_i-xxviii_1.indd 14 03/12/18 3:05 PM

Michael Haselkorn, Bentley College

Daniel A. Hinchliffe, Florida Atlantic University

M. Zafar Iqbal, Cal State Poly University–Pomona

Richard Kelsey, NOVA Southeastern University

Larry N. Killough, Virginia Tech

Larissa Kyj, Rowan University

Randall E. LaSalle, West Chester University of Pennsylvania

P. Michael McLain, Hampton University

Kathleen Metcalf, Muscatine Community College

Karen Nunez, North Carolina State University

Marge O’Reilly-Allen, Rider University

Tamara Phelan, Northern Illinois University

Jeanette Ramos-Alexander, New Jersey City University

Anwar Salimi, Cal State Poly University–Pomona

Kathleen Sevigny, Bridgewater State College

Kenneth Sinclair, Lehigh University

Ola Smith, Western Michigan University

Cynthia Sneed, Jacksonville State University

Swaminathan Sridaran, Northwestern University

Verlindsey Stewart, J.F. Drake State Technical College

Kim Tan, California State University–Stanislaus

Debra Warren, Chadron State College

Thomas Zeller, Loyola University at Chicago

Lan69479_fm_i-xxviii_1.indd 15 03/12/18 3:05 PM

xvi

Brief Contents

INTRODUCTION AND OVERVIEW

One Cost Accounting: Information for Decision Making 2

Two Cost Concepts and Behavior 42

COST ANALYSIS AND ESTIMATION

Three Fundamentals of Cost-Volume-Proﬁt Analysis 92

Four Fundamentals of Cost Analysis for Decision Making 126

Five Cost Estimation 176

COST MANAGEMENT SYSTEMS

Six Fundamentals of Product and Service Costing 226

Seven Job Costing 258

Eight Process Costing 306

Nine Activity-Based Costing 352

Ten Fundamentals of Cost Management 406

Eleven Service Department and Joint Cost Allocation 448

MANAGEMENT CONTROL SYSTEMS

Twelve Fundamentals of Management Control Systems 498

Thirteen Planning and Budgeting 536

Fourteen Business Unit Performance Measurement 582

Fifteen Transfer Pricing 620

Sixteen Fundamentals of Variance Analysis 660

Seventeen Additional Topics in Variance Analysis 710

Eighteen Performance Measurement to Support Business Strategy 746

Appendix Capital Investment Decisions: An Overview A-1

Glossary G-1

Index IND-1

Lan69479_fm_i-xxviii_1.indd 16 03/12/18 3:05 PM

xvii

Step into the Real World v

Cost Accounting: Information for

Decision Making 2

Business Application: Understanding Costs in a

Small Business 3

Value Creation in Organizations 3

Why Start with Value Creation? 3

Value Chain 4

Supply Chain and Distribution Chain 5

Business Application: Choosing Where to Produce

in the Supply Chain 5

Using Cost Information to Increase Value 5

Accounting and the Value Chain 6

Accounting Systems 6

Financial Accounting 6

Cost Accounting 6

Cost Accounting, GAAP, and IFRS 7

Customers of Cost Accounting 7

Our Framework for Assessing Cost

Accounting Systems 8

The Manager’s Job Is to Make Decisions 8

Decision Making Requires Information 8

Finding and Eliminating Activities That

Don’t Add Value 9

Identifying Strategic Opportunities

Using Cost Analysis 9

Owners Use Cost Information to

Evaluate Managers 9

Cost Data for Managerial Decisions 10

Costs for Decision Making 10

Business Application: Reducing Costs by Making

Small Changes 11

Costs for Control and Evaluation 11

Different Data for Different Decisions 14

Trends in Cost Accounting throughout

the Value Chain 14

Cost Accounting in Research and

Development (R&D) 14

Cost Accounting in Design 15

Cost Accounting in Purchasing 15

Cost Accounting in Production 15

Cost Accounting in Marketing 16

Cost Accounting in Distribution 16

Cost Accounting in Customer Service 16

Enterprise Resource Planning 17

Creating Value in the Organization 17

Key Financial Players in the Organization 17

Choices: Ethical Issues for Accountants 18

What Makes Ethics So Important? 19

Ethics 20

The Sarbanes-Oxley Act of 2002 and Ethics 20

Business Application: Accounting Decisions at

Tesco: Choices and Consequences 21

Cost Accounting and Other

Business Disciplines 21

The Debrief 22

Summary 22

Key Terms 22

Appendix: Institute of Management

Accountants Code of Ethics 23

Review Questions 25

Critical Analysis and Discussion Questions 25

Exercises 26

Problems 30

Contents

Lan69479_fm_i-xxviii_1.indd 17 03/12/18 3:05 PM

xviii

Integrative Cases 38

Solutions to Self-Study Questions 40

Cost Concepts and Behavior 42

Business Application: Calculating the Costs of

E-Books versus Paper Books 43

What Is a Cost? 44

Cost versus Expenses 44

Presentation of Costs in Financial

Statements 45

Service Organizations 46

Retail and Wholesale Companies 46

Manufacturing Companies 48

Direct and Indirect Manufacturing

(Product) Costs 48

Prime Costs and Conversion Costs 49

Nonmanufacturing (Period) Costs 49

Cost Allocation 50

Direct versus Indirect Costs 51

Business Application: Indirect Costs and

Allocating Costs to Contracts 52

Details of Manufacturing Cost Flows 52

How Costs Flow through the Statements 53

Income Statements 53

Cost of Goods Manufactured and Sold 54

Direct Materials 54

Work in Process 54

Finished Goods Inventory 55

Cost of Goods Manufactured and Sold

Statement 55

Business Application: Manufacturing or

Service: Not Always Clear 57

Cost Behavior 57

Fixed versus Variable Costs 57

Components of Product Costs 59

Unit Fixed Costs Can Be Misleading for

Decision Making 60

How to Make Cost Information More

Useful for Managers 63

Fundamentals of Cost-Volume-

Proﬁt Analysis 92

Cost-Volume-Profit Analysis 93

Business Application: Cost-Volume-Profit Analysis

and On-Demand Services 93

Profit Equation 94

CVP Example 95

Graphic Presentation 98

Profit-Volume Model 99

Use of CVP to Analyze the Effect of Different

Cost Structures 100

Business Application: Break-Even Analysis Used

by “Big Oil” 101

Margin of Safety 101

CVP Analysis with Spreadsheets 102

Extensions of the CVP Model 103

Income Taxes 103

Multiproduct CVP Analysis 103

Alternative Cost Structures 105

Assumptions and Limitations of CVP

Analysis 105

The Debrief 106

Summary 106

Key Terms 107

Review Questions 107

Critical Analysis and Discussion Questions 108

Exercises 108

Problems 114

Integrative Case 122

Solutions to Self-Study Questions 124

Gross Margin versus Contribution

Margin Income Statements 64

Developing Financial Statements for

Decision Making 64

The Debrief 66

Summary 66

Key Terms 67

Review Questions 68

Critical Analysis and Discussion Questions 68

Exercises 69

Problems 80

Integrative Cases 89

Solutions to Self-Study Questions 89

Contents

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Fundamentals of Cost Analysis for

Decision Making 126

Business Application: Cost Analysis and the

Choice of Sales Channels 127

Differential Analysis 128

Differential Costs versus Total Costs 128

Differential Analysis and Pricing

Decisions 129

Short-Run versus Long-Run Pricing

Decisions 129

Short-Run Pricing Decisions: Special Orders 130

Long-Run Pricing Decisions 132

Long-Run versus Short-Run Pricing:

Is There a Difference? 132

Cost Analysis for Pricing 133

Business Application: Take-Back Laws and

Product Design 134

Legal Issues Relating to Costs and

Sales Prices 134

Predatory Pricing 134

Dumping 135

Price Discrimination 135

Peak-Load Pricing 136

Price Fixing 136

Use of Differential Analysis for Production

Decisions 136

Make-It or Buy-It Decisions 137

Make-or-Buy Decisions Involving

Differential Fixed Costs 137

Opportunity Costs of Making 140

Decision to Add or Drop a Product

Line or Close a Business Unit 142

Product Choice Decisions 144

The Theory of Constraints 147

The Debrief 149

Summary 149

Key Terms 150

Review Questions 150

Critical Analysis and Discussion Questions 151

Exercises 152

Problems 157

Integrative Cases 171

Solutions to Self-Study Questions 173

Cost Estimation 176

Why Estimate Costs? 177

Basic Cost Behavior Patterns 177

Business Application: Understanding Fixed and

Variable Costs for Online Sales 178

What Methods Are Used to Estimate Cost

Behavior? 178

Engineering Method 178

Account Analysis Method 179

Statistical Cost Estimation 181

Business Application: Using Statistical

Analysis to Improve Profitability 186

Multiple Regression 187

Practical Implementation Problems 188

Learning Phenomenon 190

Business Application: Learning Curves 190

Applications 192

How Is an Estimation Method Chosen? 193

Data Problems 193

Effect of Different Methods on Cost

Estimates 194

The Debrief 196

Summary 196

Key Terms 197

Appendix A: Regression Analysis Using

Microsoft Excel 197

Appendix B: Learning Curves 202

Review Questions 203

Critical Analysis and Discussion Questions 204

Exercises 205

Problems 213

Integrative Case 224

Solutions to Self-Study Questions 225

Fundamentals of Product and

Service Costing 226

Cost Management Systems 227

Reasons to Calculate Product or Service Costs 228

Business Application: Understanding How

Resources and Their Costs Relate to

Revenues and Profits 228

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Contents

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Cost Allocation and Product Costing 228

Cost Flow Diagram 229

Fundamental Themes Underlying the Design of

Cost Systems for Managerial Purposes 229

Costing in a Single Product, Continuous

Process Industry 230

Basic Cost Flow Model 230

Costing with No Work-in-Process Inventories 230

Costing with Ending Work-in-Process

Inventories 231

Costing in a Multiple Product, Discrete

Process Industry 232

Predetermined Overhead Rates 234

Product Costing of Multiple Products 234

Choice of the Allocation Base for Predetermined

Overhead Rate 235

Choosing among Possible Allocation Bases 236

Multiple Allocation Bases and Two-Stage

Systems 237

Choice of Allocation Bases 238

Different Companies, Different Production and

Costing Systems 239

Operations Costing: An Illustration 241

The Debrief 242

Summary 242

Key Terms 243

Review Questions 243

Critical Analysis and Discussion Questions 243

Exercises 244

Problems 250

Integrative Cases 254

Solutions to Self-Study Questions 256

Job Costing 258

Defining a Job 259

Using Accounting Records in a Job Shop 260

Computing the Cost of a Job 260

Production Process at Gupta Designs 260

Records of Costs at Gupta Designs 260

How Manufacturing Overhead Costs Are

Recorded at Gupta Designs 264

The Job Cost Sheet 266

Over- and Underapplied Overhead 267

An Alternative Method of Recording and

Applying Manufacturing Overhead 268

Multiple Allocation Bases: The Two-Stage

Approach 271

Summary of Steps in a Job Costing System 271

Using Job Costing in Service Organizations 271

Ethical Issues and Job Costing 273

Misstating the Stage of Completion 274

Charging Costs to the Wrong Jobs 274

Business Application: Cost Allocation and

Government Contracts 274

Misrepresenting the Cost of Jobs 274

Managing Projects 276

Business Application: Assessing Product

Profitability for Products with Large

Development Expenses and Long

Product Lives 276

The Debrief 277

Summary 278

Key Terms 278

Review Questions 278

Critical Analysis and Discussion Questions 279

Exercises 279

Problems 288

Integrative Cases 301

Solutions to Self-Study Questions 304

Process Costing 306

Determining Equivalent Units 307

Using Product Costing in a Process Industry 309

Step 1: Measure the Physical Flow of

Resources 309

Step 2: Compute the Equivalent Units of

Production 309

Business Application: Overstating Equivalent

Units to Commit Fraud 310

Step 3: Identify the Product Costs for Which to

Account 311

Time Out! We Need to Make an Assumption

about Costs and the Work-in-Process

Inventory 311

Contents

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xxi

Step 4: Compute the Costs per Equivalent Unit:

Weighted Average 312

Step 5: Assign Product Cost to Batches of Work:

Weighted-Average Process Costing 312

Reporting This Information to Managers:

The Production Cost Report 313

Sections 1 and 2: Managing the Physical

Flow of Units 314

Sections 3, 4, and 5: Managing Costs 315

Assigning Costs Using First-In, First-Out (FIFO)

Process Costing 315

Step 1: Measure the Physical Flow of Resources 316

Step 2: Compute the Equivalent Units of

Production 316

Step 3: Identify the Product Costs for

Which to Account 318

Step 4: Compute the Costs per

Equivalent Unit: FIFO 318

Step 5: Assign Product Cost to

Batches of Work: FIFO 319

How This Looks in T-Accounts 319

Determining Which Is Better: FIFO or

Weighted Average? 320

Computing Product Costs: Summary

of the Steps 320

Using Costs Transferred in from Prior

Departments 321

Who Is Responsible for Costs Transferred in

from Prior Departments? 322

Choosing between Job and Process Costing 324

Operation Costing 324

Product Costing in Operations 325

Operation Costing Illustration 325

Comparing Job, Process, and

Operation Costing 327

The Debrief 328

Summary 328

Key Terms 329

Review Questions 329

Critical Analysis and Discussion Questions 330

Exercises 330

Problems 338

Integrative Cases 347

Solutions to Self-Study Questions 349

Activity-Based Costing 352

Reported Product Costs and Decision Making 353

Dropping a Product 353

The Death Spiral 355

Two-Stage Cost Allocation 356

Two-Stage Cost Allocation and the Choice of Cost

Drivers 357

Plantwide versus Department-Specific Rates 360

Choice of Cost Allocation Methods: A Cost-

Benefit Decision 360

Activity-Based Costing 361

Business Application: Activity-Based Costing in a

Not-for-Profit 362

Developing Activity-Based Costs 362

Cost Hierarchies 364

Business Application: The ABC Cost Hierarchy—

Maintenance Costs for an Airline 365

Activity-Based Costing Illustrated 365

Step 1: Identify the Activities 366

Step 2: Identify the Cost Drivers 366

Step 3: Compute the Cost Driver Rates 366

Step 4: Assign Costs Using Activity-Based

Costing 366

Unit Costs Compared 367

Cost Flows through Accounts 369

Choice of Activity Bases in Modern Production

Settings 370

Business Application: Evidence on the Benefits of

Activity-Based Costing 371

Activity-Based Costing in Administration 371

Who Uses ABC? 372

Time-Driven Activity-Based Costing 373

Developing Time-Driven Activity-Based Costs 373

Business Application: What Are a Hospital’s

Costs? 375

Extensions of TDABC 375

The Debrief 376

Summary 376

Key Terms 377

Review Questions 377

Contents

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Critical Analysis and Discussion Questions 377

Exercises 378

Problems 389

Integrative Cases 399

Solutions to Self-Study Questions 404

Fundamentals of CostManagement 406

Using Activity-Based Cost Management to

Add Value 407

Using Activity-Based Cost Information to Improve

Processes 408

Using Activity-Based Cost Management in a

Service Setting 409

Lean Manufacturing and Activity-Based Cost

Management 409

Using Cost Hierarchies 410

Managing the Cost of Customers and

Suppliers 411

Business Application: Customer Profitability—

Revenue and Cost Effects 411

Using Activity-Based Costing to Determine the

Cost of Customers and Suppliers 412

Determining Why the Cost of Customers

Matters 414

Using Cost of Customer Information to

Manage Costs 414

Business Application: The Importance of Good

Data in Analyzing Customer Profitability: The

Case of DHL 415

Determining the Cost of Suppliers 415

Capturing the Cost Savings 416

Managing the Cost of Capacity 417

Using and Supplying Resources 417

Computing the Cost of Unused Capacity 419

Assigning the Cost of Unused Capacity 421

Business Application: Filling Excess Capacity

“Below Cost” 421

Seasonal Demand and the Cost of Unused

Capacity 422

Managing the Cost of Quality 424

How Can We Limit Conflict between Traditional

Managerial Accounting Systems and Total Quality

Management? 424

What Is Quality? 424

What Is the Cost of Quality? 425

Trade-Offs, Quality Control, and

Failure Costs 426

Business Application: Cost Elements Included in

Reported Quality Costs 428

The Debrief 429

Summary 429

Key Terms 430

Review Questions 430

Critical Analysis and Discussion Questions 430

Exercises 431

Problems 440

Integrative Cases 445

Solutions to Self-Study Questions 446

Service Department and Joint Cost

Allocation 448

Service Department Cost Allocation 449

Business Application: Outsourcing Information

Services—Managed Service Providers 450

Methods of Allocating Service

Department Costs 451

Allocation Bases 451

Direct Method 452

Step Method 455

Business Application: Step Method at Stanford

University 458

Reciprocal Method 458

Comparison of Direct, Step, and Reciprocal

Methods 359

The Reciprocal Method and Decision Making 462

Allocation of Joint Costs 464

Joint Costing Defined 464

Reasons for Allocating Joint Costs 465

Joint Cost Allocation Methods 465

Net Realizable Value Method 465

Physical Quantities Method 468

Evaluation of Joint Cost Methods 469

Deciding Whether to Sell Goods Now or Process

Them Further 469

Business Application: Different Demands for

Different Parts 470

xxii

Contents

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Deciding What to Do with By-Products 470

The Debrief 471

Summary 472

Key Terms 473

Appendix: Calculation of the Reciprocal

Method Using Computer Spreadsheets 473

Review Questions 475

Critical Analysis and Discussion Questions 475

Exercises 476

Problems 482

Integrative Cases 492

Solutions to Self-Study Questions 493

Fundamentals of Management Control

Systems 498

Why a Management Control System? 499

Alignment of Managerial and Organizational

Interests 500

Evolution of the Control Problem: An Ex ample 500

Decentralized Organizations 500

Why Decentralize the Organization? 501

Advantages of Decentralization 501

Disadvantages of Decentralization 502

Business Application: The Benefits and Costs of

Decentralized Decision Making 502

Framework for Evaluating Management Control

Systems 503

Organizational Environment and Strategy 503

Results of the Management Control System 503

Elements of a Management Control System 504

Balancing the Elements 504

Delegated Decision Authority: Responsibility

Accounting 505

Cost Centers 505

Discretionary Cost Centers 505

Revenue Centers 506

Profit Centers 506

Investment Centers 506

Responsibility Centers and Organization

Structure 506

Measuring Performance 507

Two Basic Questions 508

Business Application: Teacher Pay and

Student Performance 508

Cost Centers 508

Revenue Centers 509

Profit Centers 509

Investment Centers 509

Evaluating Performance 509

Relative Performance versus Absolute

Performance Standards 510

Evaluating Managers’ Performance versus

Economic Performance of the Responsibility

Center 510

Relative Performance Evaluations in

Organizations 510

Compensation Systems 511

Business Application: Performance Measures and

Incentives—Veterans Affairs Hospitals 511

Business Application: Beware of the “Kink” 512

Illustration: Corporate Cost Allocation 512

Incentive Problems with Allocated Costs 513

Effective Corporate Cost Allocation System 513

Do Performance Evaluation Systems Create

Incentives to Commit Fraud? 514

Business Application: An Accounting Scandal at

Toshiba 515

Internal Controls to Protect Assets and Provide

Quality Information 516

Internal Auditing 517

The Debrief 517

Summary 517

Key Terms 518

Review Questions 518

Critical Analysis and Discussion Questions 519

Exercises 520

Problems 524

Integrative Cases 529

Solutions to Self-Study Questions 534

Planning and Budgeting 536

How Strategic Planning Increases

Competitiveness 537

Business Application: Using the Budget to Help

Manage Cash Flow 538

xxiii

Contents

Lan69479_fm_i-xxviii_1.indd 23 03/12/18 3:05 PM

xxiv

Overall Plan 538

Organization Goals 538

Strategic Long-Range Profit Plan 538

Master Budget (Tactical Short-Range Profit Plan):

Tying the Strategic Plan to the Operating Plan 539

Human Element in Budgeting 540

Value of Employee Participation 540

Developing the Master Budget 540

Where to Start? 541

Sales Forecasting 541

Comprehensive Illustration 543

Forecasting Production 543

Forecasting Production Costs 544

Direct Labor 545

Overhead 546

Completing the Budgeted Cost of Goods Sold 547

Revising the Initial Budget 547

Marketing and Administrative Budget 548

Pulling It Together into the Income Statement 549

Key Relationships: The Sales Cycle 550

Using Cash Flow Budgets to Estimate Cash

Needs 550

Multiperiod Cash Flows 550

Business Application: The “Curse” of Growth 552

Planning for the Assets and Liabilities on the

Budgeted Balance Sheets 553

Big Picture: How It All Fits Together 553

Budgeting in Retail and Wholesale

Organizations 553

Budgeting in Service Organizations 556

Business Application: Budget Is the Law in

Government 556

Ethical Problems in Budgeting 556

Business Application: “Use It or Lose It” 557

Budgeting under Uncertainty 557

The Debrief 558

Summary 559

Key Terms 559

Review Questions 560

Critical Analysis and Discussion Questions 560

Exercises 560

Problems 569

Integrative Cases 577

Solutions to Self-Study Questions 579

Business Unit Performance Measurement 582

Divisional Performance Measurement 583

Business Application: What Determines Whether

Firms Use Divisional Measures forMeasuring

Divisional Performance? 583

Accounting Income 584

Computing Divisional Income 584

Advantages and Disadvantages of Divisional

Income 585

Some Simple Financial Ratios 585

Return on Investment 586

Performance Measures for Control: A Short

Detour 587

Limitations of ROI 588

Business Application: Performance Measurement

at Walmart 590

Residual Income Measures 591

Limitations of Residual Income 591

Economic Value Added (EVA) 592

Business Application: EVA at Best Buy 593

Limitations of EVA 593

Business Application: Does Using Residual

Income as a Performance Measure

AffectManagers’ Decisions? 594

Divisional Performance Measurement:

A Summary 595

Measuring the Investment Base 595

Gross Book Value versus Net Book Value 595

Historical Cost versus Current Cost 596

Beginning, Ending, or Average Balance 598

Other Issues in Divisional Performance

Measurement 598

The Debrief 599

Summary 599

Key Terms 599

Review Questions 600

Critical Analysis and Discussion Questions 600

Contents

Lan69479_fm_i-xxviii_1.indd 24 03/12/18 3:05 PM

Exercises 600

Problems 605

Integrative Cases 611

Solutions to Self-Study Questions 617

Transfer Pricing 620

What Is Transfer Pricing and Why Is It

Important? 621

Business Application: Transfer Pricing at

Weyerhaeuser 622

Determining the Optimal Transfer Price 622

The Setting 623

Determining Whether a Transfer Price Is

Optimal 624

Case 1: A Perfect Intermediate Market

for Milk 624

Business Application: Transfer Pricing in State-

Owned Enterprises 625

Case 2: No Intermediate Market 625

Optimal Transfer Price: A General Principle 628

Other Market Conditions 628

Applying the General Principle 629

How to Help Managers Achieve Their Goals While

AchievingtheOrganization’s Goals 630

Top-Management Intervention in Transfer

Pricing 630

Centrally Established Transfer Price Policies 631

Establishing a Market Price Policy 631

Establishing a Cost-Based Policy 631

Alternative Cost Measures 632

Remedying Motivational Problems of Transfer

Pricing Policies 633

Negotiating the Transfer Price 634

Imperfect Markets 634

Global Practices 635

Multinational Transfer Pricing 635

Business Application: Tax Considerations in

Transfer Pricing 637

Segment Reporting 637

The Debrief 638

Summary 638

Key Terms 639

Appendix: Case 1A: Perfect Intermediate Markets—

Quality Differences 639

Review Questions 641

Critical Analysis and Discussion Questions 641

Exercises 641

Problems 647

Integrative Cases 656

Solutions to Self-Study Questions 658

Fundamentals of Variance Analysis 660

Using Budgets for Performance Evaluation 661

Profit Variance 662

Business Application: When a Favorable Variance

Might Not Mean “Good” News 663

Why Are Actual and Budgeted Results

Different? 664

Flexible Budgeting 664

Comparing Budgets and Results 665

Sales Activity Variance 665

Profit Variance Analysis as a Key

Tool for Managers 667

Sales Price Variance 667

Variable Production Cost Variances 667

Fixed Production Cost Variance 667

Marketing and Administrative Variances 667

Performance Measurement and

Control in a Cost Center 669

Variable Production Costs 669

Variable Cost Variance Analysis 670

General Model 670

Direct Materials 671

Direct Labor 674

Variable Production Overhead 675

Variable Cost Variances Summarized in

Graphic Form 677

Fixed Cost Variances 678

Fixed Cost Variances with Variable

Costing 678

Absorption Costing: The Production

Volume Variance 679

xxv

Contents

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Summary of Overhead Variances 681

Key Points 681

Business Application: Does Standard Costing

Lead to Waste? 682

The Debrief 682

Summary 682

Key Terms 683

Appendix: Recording Costs in a Standard

Cost System 684

Review Questions 686

Critical Analysis and Discussion Questions 687

Exercises 687

Problems 696

Integrative Cases 705

Solutions to Self-Study Questions 708

Additional Topics in Variance Analysis 710

Profit Variance Analysis When Units Produced

Do Not Equal Units Sold 711

Business Application: Financial Analysis and

Variance Analysis 713

Reconciling Variable Costing Budgets and

Full Absorption Income Statements 713

Materials Purchases Do Not Equal

Materials Used 714

Market Share Variance and Industry

Volume Variance 716

Sales Activity Variances with Multiple

Products 718

Evaluating Product Mix 718

Evaluating Sales Mix and Sales Quantity 718

Business Application: Sales Mix and Financial

Reporting 720

Production Mix and Yield Variances 720

Mix and Yield Variances in Manufacturing 720

Variance Analysis in Nonmanufacturing

Settings 723

Using the Profit Variance Analysis in Service

and Merchandise Organizations 723

Efficiency Measures 723

Mix and Yield Variances in Service

Organizations 724

Keeping an Eye on Variances and Standards 725

How Many Variances to Calculate 725

When to Investigate Variances 725

Updating Standards 726

The Debrief 726

Summary 727

Key Terms 727

Review Questions 727

Critical Analysis and Discussion Questions 728

Exercises 728

Problems 733

Integrative Cases 740

Solutions to Self-Study Questions 743

Performance Measurement to Support

Business Strategy 746

Strategy and Performance 747

The Foundation of a Successful Business

Strategy 748

Porter Framework 748

Beyond the Accounting Numbers 749

Responsibilities According to Level of

Organization 750

Business Model 751

Multiple Measures or a Single Measure of

Performance? 752

Balanced Scorecard 753

Continuous Improvement and Benchmarking 756

Business Application: Challenges to

Identifying Appropriate Benchmarking

Organizations 759

Performance Measurement for Control 760

Some Common Nonfinancial Performance

Measures 760

Customer Satisfaction Performance Measures 760

Functional Performance Measures 761

Productivity 762

Nonfinancial Performance and Activity-Based

Management 765

Objective and Subjective Performance

Measures 766

Business Application: Is There a “Fixation” on

Metrics? 766

xxvi

Contents

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xxvii

Employee Involvement 767

Business Application: Empowering Employees to

Compensate Customers for Service Failures 768

Difficulties in Implementing Nonfinancial

Performance Measurement Systems 768

Fixation on Financial Measures 768

Reliability of Nonfinancial Measures 768

Lack of Correlation between Nonfinancial

Measures and Financial Results 768

The Debrief 769

Summary 769

Key Terms 770

Review Questions 770

Critical Analysis and Discussion Questions 770

Exercises 771

Problems 776

Integrative Cases 781

Solutions to Self-Study Questions 782

Appendix

Capital Investment Decisions:

An Overview A-1

Glossary G-1

Index IND-1

Contents

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Lan69479_fm_i-xxviii_1.indd 28 03/12/18 3:05 PM

Fundamentals of

Cost Accounting

Lan69479_fm_i-xxviii_1.indd 1 03/12/18 3:05 PM

Lan69479_ch02_042-091.indd 42 29/11/18 7:58 AM

Chap

ter Two

Cost Concepts

and Behavior

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

LO 2-1 Explain the basic concept of “cost.”

LO 2-2 Explain how costs are presented in ﬁnancial statements.

LO 2-3 Explain the process of cost allocation.

LO 2-4 Understand how material, labor, and overhead costs are added to a

product at each stage of the production process.

LO 2-5 Deﬁne basic cost behaviors, including ﬁxed, variable, semivariable,

and step costs.

LO 2-6 Identify the components of a product’s costs.

LO 2-7 Understand the distinction between ﬁnancial and contribution margin

income statements.

©Reed Kaestner/Getty Images

The Decision

When I graduated in engineering several years ago,

I knew I wanted to go to work in manufacturing. I found

the idea of turning metal or plastic or wood into prod-

ucts that people could use every day was exciting to

me. I started here at Three Rivers Fabrication in the

design department, but have also worked in R&D and

manufacturing. Now I have moved into management

as the plant manager at our Peoria plant.

As an engineer, I just assumed that the cost infor-

mation provided by ﬁnance was correct. Now I am

seeing the details and having a dicult time under-

standing what all the cost terms mean. There seem to

be many terms for the same thing. Unfortunately, none

of them help me with the decisions I have to make. For

example, we are always getting requests for quotes

on products and I am not sure whether we are too

high when we don’t get the business or too low when

we do.

I am meeting later this week with Angela Berroa,

our plant comptroller. She laughed when I asked for the

meeting and said not to worry—every plant manager

she has worked for has had the same request. I hope

so, because I need to review our ﬁnancials with the

area manager next week and I want to show that I am

ready for this job.

Ingrid Jensen is the new plant manager at the Peoria

plant of Three Rivers Fabrication. The plant makes parts for

heavy equipment manufacturers selling in both the agricul-

tural and construction markets. She has been promoted into

this position based on her success in managing several

important projects on some of the company’s newest prod-

ucts. She is expected to ensure that Peoria maintains a com-

parative advantage in cost without losing their reputation for

quality and innovation. She is hoping to learn more about the

basics of costs and the terminology that cost accountants use

so she can manage more eectively.

Calculating the Costs of E-Books versus Paper Books

Business Application

Companies are interested in the costs of their products and

services for many reasons, including pricing. In computing

costs, the format of the product might make a dierence. For

example, many books, such as the one you are reading, come

in both print and electronic formats. If one format, electronic for

example, is less costly than another (print), this might make it

possible for the publisher to lower the price of the electronic

version relative to the print version.

The question then is: What is the dierence in cost of pro-

duction between an electronic and printed version of a book?

A recent article suggests the following. Based on the selling

price, the publisher receives about 50 percent from the

retailer. Another 12 to 13 percent covers the cost of production

and distribution. Finally, design, editing, marketing, and so on,

constitute another 7 percent. These percentages are based on

a retail price of $26. Of course, as you will learn later in the

chapter, many of these unit costs will change as the number of

books produced and sold increase and also on the particular

selling price.

For an electronic book distributed, for example, by Apple

Inc., the publisher pays the seller 30 percent commission. Con-

verting the text to electronic format, editing, and marketing

costs constitute about 10 percent of the selling price.

These are just some of the costs, but the discussion pro-

vides an example of ﬁrms considering the type of cost (market-

ing, for example) and how those costs will change as volume

changes. The discussion also illustrates how important it is to

be careful when using unit costs that depend on production

volumes.

Source: Rich, Motoko, “Math of Publishing Meets the E-Book,” The

New York Times, February 28, 2010.

Cost accounting systems provide information to help managers make better decisions.

Managers who use cost accounting information to make decisions need to understand the

cost terms used in their organizations. Because cost accounting systems are tailored to the

needs of individual companies, several terms are used in practice to describe the same or

similar cost concepts, depending on the use or the audience. Therefore, before we discuss

the design of cost systems to aid decision making, we introduce a set of terms that will be

used throughout the book. These terms are important to the discussion because they will

be the “language” we use to communicate for the remainder of the book. These terms are

Lan69479_ch02_042-091.indd 43 31/10/18 10:54 AM

44 Part I Introduction and Overview

common, but they are not universal, so you need to be aware that a company you work for

may use different terms for some of the concepts we discuss here.

In addition, managers need to understand how financial statements are commonly

prepared because this will often be the primary form in which the information is avail-

able. The effects of the decisions made by managers are shown publicly in the firm’s

published financial statements.

Although these statements allow investors to evaluate the firm, they are not useful f or

managing the business. Because most of you are familiar with traditional financial state-

ments, either from earlier course work in accounting, your own investment analysis,

or access to publicly available financial statements, we start by linking the fundamental

concepts of cost accounting to financial statements.

We discussed in Chapter 1 the differences between cost and financial accounting.

Although the two systems serve different purposes, they are not completely separate. The

financial statements prepared by the firm for external reporting use information from the

cost accounting system. Fundamentally, the cost accounting system records and main-

tains the use of economic resources by the organization. We illustrate how resources are

used and costs are added to a product or service in different types of industries and how

the use (cost) of these resources is reported in the financial statements. We explain the

types of costs that managers use in making decisions. Finally, we present several dia-

grams that will help you track the different components of a product’s cost.

Exhibit 2.16 in the chapter summary highlights the most important cost concepts in

this chapter; refer to it often as you review for exams or need a quick reference.

What Is a Cost?

A cost is a sacrifice of resources. Every day, we buy many different things: clothing,

food, books, music, perhaps an automobile, and so on. When we buy one thing, we

give up (sacrifice) the ability to use these resources (typically cash or a line of credit)

to buy something else. The price of each item measures the sacrifice we must make

to acquire it. Whether we pay cash or use another asset, whether we pay now or later

(by using a credit card), the cost of the item acquired is represented by what we forgo

as a result.

LO 21

Explain the basic

concept of “cost.”

cost

Sacriﬁce of resources.

Cost versus Expenses

It is important to distinguish cost from expense. An expense is a cost charged against

revenue in an accounting period; hence, expenses are deducted from revenue in that

accounting period. We incur costs whenever we give up (sacrifice) resources, regardless

of whether we account for it as an asset or an expense. (We may even incur costs that the

financial accounting system never records as an asset or expense. An example is lost

sales.) If the cost is recorded as an asset (for example, prepaid rent for an office building),

it becomes an expense when the asset has been consumed (i.e., the building has been used

for a period of time after making the prepayment). In this book, we use the term expense

only when referring to external financial reports.

expense

Cost that is charged against

revenue in an accounting

period.

The focus of cost accounting is on costs, not expenses. Generally accepted account-

ing principles (GAAP) and regulations such as the income tax laws specify when costs

are to be treated as expenses. Although the terms cost and expense are sometimes used as

synonyms in practice, we use cost in this book for all managerial purposes.

The two major categories of costs are outlay costs and opportunity costs. An outlay

cost is a past, present, or future cash outflow. Consider the cost of a college education—

clearly, the cash outflows for tuition, books, and fees are outlay costs. Cash is not all that

college students sacrifice; they also sacrifice their time to get a college education. This

sacrifice of time is an opportunity cost. Opportunity cost is the forgone benefit that

outlay cost

Past, present, or future cash

outﬂow.

opportunity cost

Forgone beneﬁt from the best

(forgone) alternative course

ofaction.

Lan69479_ch02_042-091.indd 44 31/10/18 10:54 AM

Chapter 2 Cost Concepts and Behavior 45

could have been realized from the best forgone alternative use of a resource.

For exam-

ple, many students give up jobs to take the time to earn a college degree. The forgone

income is part of the cost of getting a college degree and is the forgone benefit that could

be realized from an alternative use of a scarce resource—time. These are other examples

of opportunity costs:

In some definitions, the outlay cost is also an opportunity cost because you forgo the use of the cash

that could be used to purchase other goods and services. In this text, we reserve the use of the term

opportunity costs to those costs that are not outlay costs.

∙

The opportunity cost of funds that you invest in a bank certificate of deposit is the

forgone interest you could have earned on another security, assuming that both secu-

rities are equal in risk and liquidity.

∙

The opportunity cost of spending spring break in Florida is the forgone income from

a temporary job; the opportunity cost of taking a tempor

ary job during spring break

is the forgone pleasure of a trip to Florida.

∙

The opportunity cost of time spent working on one question on an examination is the

forgone benefit of time spent working on another ques

tion.

Of course, no one can ever know all of the possible opportunities available at any

moment. Hence, some opportunity costs are undoubtedly not considered. Accounting

systems typically record outlay costs but not opportunity costs. As a result, it is easy for

managers to overlook or ignore opportunity costs in making decisions. A well-designed

cost accounting system presents all relevant information to managers, including opportu-

nity costs that they may otherwise ignore in decision making.

Presentation of Costs in Financial Statements

We are concerned with information for use by managers. Therefore, when we present or

discuss financial statements, we assume that the statements are prepared for internal man-

agement use, not for external reporting. We also focus on operating profit, the excess of

operating revenues over the operating costs incurred to generate those revenues. This

figure differs from net income, which is operating profit adjusted for interest, income

taxes, extraordinary items, and other adjustments required to comply with GAAP or other

regulations such as tax laws.

LO 22

Explain how costs are

presented in ﬁnancial

statements.

operating proﬁt

Excess of operating revenues

over the operating costs

necessary to generate those

revenues.

It is important to remember that information from the cost accounting system is just a

means to an end; the final products are managerial decisions and actions (and the change

in firm value) that result from the information generated by the system. We are not seeking

the “most accurate” information; we are looking for the best information, understanding

how the information is used in decision making, and recognizing the cost of preparing and

using the information. The following sections present some examples of how cost informa-

tion appears in financial statements prepared for managers. These are basic statements on

which we build. As we proceed through the book, we show you how to improve these

basic statements and the data they contain to make them more informative.

A generic income statement for a firm, a division, a product, or any unit is shown in

Exhibit 2.1. It summarizes the revenues (sales) of the unit and subtracts the costs of the

unit. The costs include the cost of the goods or service the activity sells. Although the

basic form of the income statement is the same regardless of the product or service an

organization sells, the details, especially with respect to costs, vary depending on how the

organization acquires the resources used to produce the product or service.

In the sections that follow, we illustrate three types of

income statements where the organization sells (1) a service,

(2) a product that it acquires from another organization

(a retailer), or (3) a product that it builds using materials

from other organizations (a manufacturer). It is important to

Exhibit 2.1

Generic Income

Statement

Revenue . . . . . . XXX

Costs. . . . . . . . . YYY

Operating proﬁt . ZZZ

Lan69479_ch02_042-091.indd 45 31/10/18 10:54 AM

46 Part I Introduction and Overview

remember, however, that most firms are made up of activities that combine features of all

three types of activities. Even in a manufacturing firm, you might find income statements

for a unit, such as repair services, that look like those of a service business.

Similarly, many service firms, such as those in financial services, have important

transactions and billing functions that use repeatable, discrete processes, not unlike many

manufacturing processes. Because service firms have no inventory to value, some firms

have not taken steps to understand how these discrete processes are associated with costs.

However, as competitive pressures force firms to become more efficient and effective,

even service firms have started to understand how important it is to associate costs and

revenues with the distinct services they provide so that they can better evaluate the value-

added equation that we discussed in Chapter 1. Service firms are now adopting cost man-

agement practices that were originally developed in manufacturing. For example, banks

and brokerage firms are using activity-based costing and distribution firms are using cus-

tomer profitability analysis to disentangle selling, general, and administrative (SG&A)

costs. The methods of cost analysis that were first developed in manufacturing are now

being translated into services to meet the universal demands for understanding costs as a

part of strategic management of the value proposition.

Service Organizations

A service company provides customers with an intangible product. For example, consult-

ing firms provide advice and analyses. Traditionally, labor costs were the most significant

cost category for most service organizations. However, as information services become

increasingly important, this is changing. Some service firms provide information, and for

these companies information technology can represent the major cost. Other firms pro-

vide information analysis, and for these firms labor costs will likely remain the most

important single cost.

The costs associated with RPE Associates, a compensation consulting firm, are

shown in the income statement in Exhibit 2.2. The line item cost of services sold includes

the costs of billable hours, which are the hours billed to clients plus the cost of other

items billed to clients (for example, charges for performing an information search or

printing reports). Costs that are not part of services billable to clients are included in the

marketing and administrative costs. At RPE, many managers report costs both in the cost

of services sold (working with a client) and in marketing and administrative costs (devel-

oping project proposals for new business). The distinction is based on the nature of the

work, not who performs the task.

Retail and Wholesale Companies

When you buy food, clothes, or a book, you are buying from a retail (or maybe a whole-

sale) firm. Retail and wholesale firms sell but do not make a tangible product. The income

statement for these companies includes revenue and cost items as does that for service

companies, but for retailers and wholesalers, it has an added category of cost information

(called cost of goods sold) to track the cost of the tangible goods they buy and sell.

Exhibit 2.2

Income Statement for a

Service Company

RPE ASSOCIATES

Income Statement

For the Year Ended December 31, Year 2

($000)

Sales revenue

..........................

$,

Cost of services sold

..................... ,

Gross margin ......................... $ ,

Marketing and administrative costs

........ ,

Operating proﬁt

....................... $ ,

Lan69479_ch02_042-091.indd 46 31/10/18 10:54 AM

Chapter 2 Cost Concepts and Behavior 47

Exhibit 2.3

Income Statement for a

Merchandise Company

SOUTHWEST OFFICE PRODUCTS

Income Statement

For the Year Ended December 31, Year 2

($000)

Sales revenue ....................................................... $,

Cost of goods sold (see following statement) ............................

,

Gross margin ...................................................... $,

Marketing and administrative costs

..................................... 

Operating proﬁt

.................................................... $ 

Cost of Goods Sold Statement

For the Year Ended December 31, Year 2

($000)

Beginning inventory .................................... $ 

Cost of goods purchased

Merchandise cost .................................... $,

Transportation-in costs................................ 

Total cost of goods purchased ......................... ,

Cost of goods available for sale

.......................... $,

Less cost of goods in ending inventory

.................... 

Cost of goods sold ................................... $,

Lan69479_ch02_042-091.indd 47 31/10/18 10:54 AM

Southwest Office Products is a retail company that sells office supplies, such as

paper products and computer accessories. The company’s income statement and cost of

goods sold statement are shown in Exhibit 2.3. The cost of goods sold statement shows

how the cost of goods sold was computed. Exhibit 2.3 shows the following information

for Southwest:

∙

It had a $300,000 beginning inventory on January 1. This represents the cost of the

paper, writing supplies, toner cartridges, and ot

her salable items on hand at the begin-

ning of the year.

∙

The company purchased $1,830,000 of goods during the year and had transportation-in

costs of $90,000. Therefore, its total cos

t of goods purchased was $1,920,000

(= $1,830,000 for the purchases + $90,000 for the transportation-in costs).

∙

Based on the information so far, Southwest had a $2,220,000 cost of items available

for sale (= $1,920,000 to

tal cost of goods purchased + $300,000 from beginning

inventory). The $2,220,000 is the cost of the goods that the company could have sold,

in other words, the cost of goods available for sale.

At the end of the year, the company still had on hand inventory costing $445,000.

Therefore, Southwest sold items costing $1,775,000 (= $2,220,000 − $445,000).

The income statement summarizes Southwest’s operating performance with the fol-

lowing information:

∙

Sales revenue for the year was $3,225,000.

∙

The cost of goods sold amount, $1,775,000, came from the cost of goods sold state-

ment. Therefore, the gross margin (t

he difference between sales revenue and cost of

goods sold) is $1,450,000 (= $3,225,000 sales revenue − $1,775,000 cost of goods

sold). If you were Southwest’s manager, you would know that, on average, every $1

of sales gave you about $0.45 (= $1,450,000 ÷ $3,225,000) to cover marketing and

administrative costs and earn a profit.

∙

The income statement also shows that marketing and administrative costs were

$825,000, and operating profits were $625,000 (=

$1,450,000 gross mar gin—$825,000

marketing and administrative costs).

48 Part I Introduction and Overview

The term cost of goods sold includes only the actual costs of the goods that were sold.

It does not include the costs required to sell them such as the salaries of salespeople, which

are marketing costs, or the salaries of top executives, which are administrative costs.

cost of goods sold

Expense assigned to products

sold during a period.

Compare the income statement for Southwest Office Products with that for the ser vice

company, RPE Associates (Exhibit 2.2). Like other retail and wholesale o rganizations,

Southwest has an entire category of amounts that do not appear in a ser vice company’s

income statement. This category appears in the cost of goods sold statement, which

accounts for the inventories, purchases, and sales of tangible goods. By contrast, the ser-

vice company does not “purchase” anything to be held in inventory until sold. Service

companies are generally most interested in measuring the cost of providing services while

retail and wholesale firms focus on two items. The gross margin reflects the ability to price

the products, while the marketing and administrative costs reflect relative efficiency in

operating the business itself.

Manufacturing Companies

You are probably acquainted with the term cost of goods sold from a financial account-

ing course. It is likely that most, if not all, of the examples you encountered in study-

ing financial accounting were retail firms. The reason is that in financial accounting

the focus is on preparing and presenting the statements. In a retail firm, the unit cost

of an item sold is known because it was purchased from a third party. A manufacturing

company has a more complex income statement than do service or retail/wholesale

companies. Whereas the retailer/wholesaler purchases goods for sale, the manufac-

turer makes them. For decision making, it is not enough for the manufacturer to know

how much it paid for a good; it must also know the different costs associated with

making it.

Financial reporting distinguishes costs in a manufacturing firm based on when the

costs are recognized as expenses on the financial statements. Product costs are those

costs assigned to units of production and recognized (expensed) when the product is sold.

Product (manufacturing) costs follow the product through inventory. Period costs

(nonmanufacturing costs) include all other costs and are expensed as they are incurred.

Although we are not directly concerned with financial statement preparation in this book,

the cost accounting system must be able to provide cost information for the financial

reporting system.

product costs

Costs assigned to the

manufacture of products and

recognized for ﬁnancial

reporting when sold.

period costs

Costs recognized for ﬁnancial

reporting when incurred.

Before we present example statements for a manufacturing firm, we need to define

some additional terms.

Direct and Indirect Manufacturing (Product) Costs

Product costs consists of two types—direct and indirect costs. Direct manufacturing

costs are those product costs that can be identified with units (or batches of units) at rela-

tively low cost. Indirect manufacturing costs are all other product costs. The glass in a

light bulb is a direct cost of the bulb. The depreciation on the light bulb manufacturing

plant is an indirect cost.

direct manufacturing costs

Product costs that can be

feasibly identiﬁed with units of

production.

indirect manufacturing costs

All product costs except direct

costs.

Direct costs are classified further into direct materials cost and direct labor cost. The

manufacturer purchases materials (for example, unassembled parts), hires workers to con-

vert the materials to a finished good, and then offers the product for sale. Thus, there are

three major categories of product costs:

1. Direct materials that can be feasibly identified directly, at relatively low cost, with

the product. (To the manufacturer, purchased parts, including transportation-in, are

included in direct materials.) Direct materials are often called raw materials. Materi-

als that cannot be identified with a specific product (for example, paper for plant

reports, lubricating oil for machines) are included in category 3.

2. Direct labor of workers who can be identified directly, at reasonable cost, with the

product. These workers transform the materials into a finished product.

direct materials

Materials that can be identiﬁed

directly with the product at

reasonable cost.

direct labor

Labor that can be identiﬁed

directly with the product at

reasonable cost.

Lan69479_ch02_042-091.indd 48 31/10/18 10:54 AM

Chapter 2 Cost Concepts and Behavior 49

3. All other costs of transforming the materials into a finished product, often referred to in

total as manufacturing overhead. Some examples of manufacturing overhead follow.

manufacturing overhead

All production costs except

direct labor and direct

materials.

∙

Indirect labor, the cost of workers who do not work directly on the product yet

are required so that the factory can operate, such as supervisors, maintenance

workers, and inventory storekeepers.

∙

Indirect materials, such as lubricants for the machinery, polishing and cleaning

materials, repair parts, and light bulbs, which are not a part of the finished

product but are necessary to manufacture it.

∙

Other manufacturing costs, such as depreciation of the factory building and

equipment, taxes on the factory assets, insurance on the factory building and

equipment, heat, light, power, and similar expenses incurred to keep the factory

operating.

Although we use manufacturing overhead in this book, common synonyms used in

practice are factory burden, factory overhead, burden, factory expense, and the unmodi-

fied word, overhead.

Prime Costs and Conversion Costs

You are likely to encounter the following two categories of costs in manufacturing com-

panies: prime costs and conversion costs. Prime costs are the direct costs, namely, direct

materials and direct labor. In some companies, managers give prime costs much attention

because they represent 80 to 90 percent of total manufacturing costs.

prime costs

Sum of direct materials

and direct labor.

In other cases, managers give most of their attention to conversion costs, which are

the costs to convert direct materials into the final product. These are the costs for direct

labor and manufacturing overhead. Managers who focus on conversion costs use a con-

trollability argument: “We can manage conversion costs. Direct materials costs are mostly

outside our control.”

conversion costs

Sum of direct labor and

manufacturing overhead.

Generally, companies with relatively low manufacturing overhead focus on manag-

ing prime costs. Companies that have high direct labor and/or manufacturing overhead

tend to be more concerned about conversion costs. In practice, you have to determine the

cost information that decision makers need to manage effectively. It is not only the rela-

tive magnitude of costs that matters in determining which costs to monitor. The important

issue is identifying the most important costs over which the firm has control. For exam-

ple, in some processing firms, the largest costs are the direct materials costs. However,

because those materials are commodities with prices set in well-functioning markets, it

may be infeasible to exercise much control over those costs other than monitoring usage.

Exhibit 2.4 summarizes the relation between conversion costs and the three elements

of manufactured product cost: direct materials, direct labor, and manufacturing overhead.

Nonmanufacturing (Period) Costs

Nonmanufacturing costs have two elements: marketing costs and administrative costs.

Marketing costs are the costs required to obtain customer orders and provide customers

with finished products. These include advertising, sales commissions, shipping costs, and

marketing departments’ building occupancy costs. Administrative costs are the costs

required to manage the organization and provide staff support, including executive and

clerical salaries; costs for legal, financial, data processing, and accounting services; and

building space for administrative personnel.

marketing costs

Costs required to obtain

customer orders and provide

customers with ﬁnished

products, including advertising,

sales commissions, and

shipping costs.

administrative costs

Costs required to manage the

organization and provide sta

support, including executive

salaries, costs of data

processing, and legal costs.

Nonmanufacturing costs are expensed periodically (often in the period they are

incurred) for financial accounting purposes. For managerial purposes, however,

managers often want to see nonmanufacturing costs assigned to products. This is

particularly true for commissions and advertising related to a specific product. For

example, managers at consumer products companies such as Procter & Gamble and

Anheuser-Busch want the cost of advertising a specific product, which can be

substantial, to be assigned to that product. For most of our purposes, this distinction

Lan69479_ch02_042-091.indd 49 31/10/18 10:54 AM

50 Part I Introduction and Overview

Exhibit 2.4 Components of Manufactured Product Cost

Labor

Direct

labor

Product

cost

Indirect

labor

Manufacturing

overhead

Materials

Direct

materials

Conversion

costs

Prime

costs

Indirect

materials

Manufacturing

utilities, rent, etc.

between m anufacturing and n onmanufacturing costs is artificial because we are

interested in the costs that products and services impose on the firm, not in the finan-

cial accounting treatment of these costs.

Sometimes distinguishing between manufacturing costs and nonmanufacturing costs

is difficult. For example, are the salaries of accountants who handle factory payrolls

manufacturing or nonmanufacturing costs? What about the rent for offices for the manu-

facturing vice president? There are no clear-cut classifications for some of these costs, so

companies usually set their own guidelines and follow them consistently.

Cost Allocation

Many costs result from several departments sharing facilities (buildings, equipment) or

services (data processing, maintenance staff). If you share an apartment with someone,

the rent is a cost to the people sharing the apartment. If we want to assign costs to each

individual, some method must be devised for assigning a share of the costs to each user.

This process of assigning costs is called cost allocation.

LO 23

Explain the process of

cost allocation.

cost allocation

Process of assigning indirect

costs to products, services,

people, business units, etc.

We discuss implications of allocating costs throughout this book. However, cost allo-

cation is a process that is familiar to most people, even those who do not study cost

accounting. First, we need some definitions. A cost object is any end to which a cost is

assigned, for example, a unit of product or service, a department, or a customer.

cost object

Any end to which a cost is

assigned; examples include a

product, a department, or a

product line.

Managers make many decisions at the level of the cost object. Should we drop this

product? How can we make this customer profitable? Costs in the cost pool are the costs

we want to assign to the cost objects. Examples are department costs, rental costs, or

travel costs a consultant incurs to visit multiple clients. The cost allocation rule is the

method or process used to assign the costs in the cost pool to the cost object.

Lan69479_ch02_042-091.indd 50 31/10/18 10:54 AM

Chapter 2 Cost Concepts and Behavior 51

cost pool

Collection of costs to be

assigned to the cost objects.

cost allocation rule

Method used to assign costs in

the cost pool to the cost

objects.

Consider the following simple example. Rockford Corporation has two divisions: East

Coast (EC) and West Coast (WC). Computing services at Rockford are centralized and pro-

vided to the two divisions by the corporate Information Systems (IS) group. Total systems

costs for the quarter are $1 million. Divisional financial statements are being prepared, and

the accountant has asked for your help in allocating these costs to the divisions.

How would you suggest the accountant proceed? You might suggest that because

there are two divisions, they share the costs equally, that is, each is charged $500,000 for

IS services. The West Coast manager argues that this is unfair because WC is much

smaller than EC. She argues that the allocation should be based on a measure of divi-

sional size, such as revenues. The East Coast manager argues that this is not right because

most of IS time is spent in the West Coast division, where the equipment is more complex

and requires more maintenance. There is often no “right” way to solve this dilemma (but

there may be some ways that result in poor decisions). As we will see throughout the

book, the allocation of indirect costs can often lead to disputes both within the firm and

between the firm and its customers. See the Business Application,Indirect Costs and

Allocating Costs to Contracts, for an example.

Let’s suppose the accountant chooses divisional revenue and that the revenue in EC

is $80 million and the revenue in WC is $20 million. Then the allocation to the two divi-

sions can be illustrated in the flowchart, or cost flow diagram, shown in Exhibit 2.5.

cost ﬂow diagram

Diagram or ﬂowchart

illustrating the cost allocation

process.

Because the East Coast division earns 80 percent (= $80 million of the total $100

million in revenues), it is assigned, or allocated, 80 percent of the IS costs, or $800,000

(= 80% of $1,000,000). Similarly, the West Coast division is assigned $200,000 (= 20%

of $1,000,000). Many of the cost allocation methods we discuss are more complex than

this simple example, but the fundamental approach is the same: (1) identify the cost

objects, (2) determine the cost pools, and (3) select a cost allocation rule. We will make

extensive use of cost flow diagrams such as the one in Exhibit 2.5 because they can help

us understand (1) how a cost system works and (2) the likely effects on the reported costs

of different cost objects from changes in the cost allocation rule.

Direct versus Indirect Costs

Any cost that can be unambiguously related to a cost object is a direct cost of that cost

object. Those that cannot be unambiguously related to a cost object are indirect costs.

We have already seen one use of this distinction in our discussion of manufacturing costs.

Accountants use the terms direct cost and indirect cost much as a non-accountant might

expect. One difficulty is that a cost may be direct to one cost object and indirect to

another. For example, the salary of a supervisor in a manufacturing department is a direct

cost of the department but an indirect cost of the individual items the department

direct cost

Any cost that can be directly

(unambiguously) related to a

cost object at reasonable cost.

indirect cost

Any cost that cannot be

directly related to a cost

object.

Exhibit 2.5

Cost Flow Diagram

Corporate IS Group

$1,000,000

% Revenue

Cost

pool

Cost

allocation

rule

Cost

objects

20%

80%

East Coast

$800,000

West Coast

$200,000

80% = $80 million revenue ÷ ($80 million + $20 million)

20% = $20 million revenue ÷ ($80 million + $20 million)

Lan69479_ch02_042-091.indd 51 31/10/18 10:54 AM

52 Part I Introduction and Overview

produces. So when someone refers to a cost as either direct or indirect, you should imme-

diately ask, direct or indirect with respect to what cost object? Units produced? A depart-

ment? A division? (When we use direct and indirect to describe labor and materials, the

cost object is the unit being produced.)

Whether a cost is considered direct or indirect also depends on the costs of linking it

to the cost object. For example, it is possible to measure the amount of lubricating oil

used to produce one unit by stopping the machine and measuring the amount of oil

required to fill the reservoir. The cost of this is prohibitive in terms of lost production, so

the oil cost is considered indirect.

Business Application

Indirect Costs and Allocating Costs to Contracts

Many contracts, especially when selling to government agen-

cies, specify prices based on the “cost” of the service or

product. As we see in this section, when there are indirect

costs, the calculated cost depends on how the indirect costs

are allocated. When a company has multiple clients, it is pos-

sible that the choice of allocation method aects the prices

(and proﬁts) although the total costs have not changed. There

is an incentive to allocate costs in a way to increase the com-

pany’s proﬁts. Depending on the terms of the contract, there

can be both ethical and legal considerations in how indirect

costs are allocated.

For example, the U.S. government is “conducting a civil and

criminal investigation into Booz Allen Hamilton’s cost accounting

and indirect cost charging practices.” When the news was

released, Booz Allen Hamilton stock lost 12 percent of its value.

Source:Armental, Maria, “Justice Department Probing Booz Allen’s

Accounting, Billing Practices with U.S.” Wall Street Journal, June 15, 2017.

Details of Manufacturing Cost Flows

The Peoria Plant of Three Rivers Fabrication is the production facility of the company.

It produces components such as pumps of various types (water, oil, fuel) for original

equipment manufacturers (OEMs), such as automobile and farm equipment companies.

Even if you have never been in a machine shop, you can imagine the process of making a

pump. It would consist of three basic steps:

∙

First, you would see metal and plastic (direct material) being delivered to the receiving

area, inspected, and then placed in the direct material inventory area (store) of the shop.

∙

Next, when it was time to produce pumps, the metal and plastic would be transported to

an assembly line. It would be fed to large mac

hines (presses, lathes, and so on) that

would turn the unformed metal and plastic into the finished pump. While the metal is

in this part of the factory, it is neither direct material nor a pump; it is work in process.

∙

Finally, the pump is complete, and it is moved out to a separate area in the factory

with other completed products. These pum

ps are finished goods and ready for sale.

LO 24

Understand how

material, labor, and

overhead costs are

added to a product at

each stage of the pro-

duction process.

work in process

Product in the production

process but not yet complete.

ﬁnished goods

Product fully completed, but

not yet sold.

Just as the manufacturing plant at Three Rivers has direct material, work-in-process,

and finished goods inventories, the cost accounting system at Three Rivers has three

major categories of inventory accounts—one category for each of these three stages:

Direct Materials Inventory, Work-in-Process Inventory, and Finished Goods Inventory.

Our goal with the cost accounting system is simple: By tracing the physical flows with

cost flows through the inventory accounts, we can represent the use of resources in the

plant to produce the finished pumps.

Each inventory account is likely to have a beginning inventory amount, additions

(debits) and withdrawals (credits) during the period, and an ending inventory based on

what is still on hand at the end of the period. Those costs added (debited) to inventory

accounts are called inventoriable costs.

inventoriable costs

Costs added to inventory

accounts.

To show how this works, Exhibit 2.6 illustrates a simplified version of the actual

production process at the Peoria Plant. It shows the stages of production from receipt of

materials through manufacturing to shipment to the finished goods warehouse.

Lan69479_ch02_042-091.indd 52 31/10/18 10:54 AM

Chapter 2 Cost Concepts and Behavior 53

Exhibit 2.6 Production Process at the Peoria Plant

The Peoria Plant receives raw metal (steel, brass, etc.) at its Direct Materials Receiv-

ing Department. The people in this department are responsible for checking each order to

be sure that it meets quality specifications and that the goods received are what were

ordered.

If the Three Rivers uses just-in-time (JIT) inventory methods, people in direct materi-

als receiving send the components—metals, plastics—to the machining line immediately.

If Three Rivers does not use JIT, people in this department send the components to a

materials warehouse until it is needed for production. Any product that has been pur-

chased but not yet transferred to manufacturing departments will be part of Direct Materi-

als Inventory on the balance sheet at the end of the accounting period.

When the production process begins, the metal moves along the machining line as it

is transformed (rods added to the pumps, individual bowls cut, and so on). Any pumps

that are not complete—that is, those still on the machining line at the end of an account-

ing period—are part of Work-in-Process Inventory on the balance sheet.

After the completed pumps are inspected, they are moved to a holding area awaiting

shipment to customers around the country. The cost of any product that is finished but not yet

sold to customers is included in Finished Goods Inventory at the end of an accounting period.

How Costs Flow through the Statements

Income Statements

Now that we understand the physical flow of the product through the process, we can use a

numerical example to show how to report revenues and expenses at Three Rivers Fabrica-

tion. The result is a typical income statement for a manufacturing company (see Exhibit 2.7).

The income statement shows that Three Rivers generated sales revenue of $40,900,000, had

cost of goods sold of $26,200,000, and incurred marketing and administrative costs of

$7,700,000 for the year, thereby generating an operating profit of $7,000,000.

Exhibit 2.7

Income Statement for a

Manufacturing Firm

THREE RIVERS FABRICATION

Income Statement

For the Year Ending December 31, Year 2

($000)

Sales revenue

......................................................

...................................

.....................................................

...............................

.......................................

$,

Cost of goods sold (see Exhibit .) ,

Gross margin $,

Less marketing and administrative costs ,

Operating proﬁt before taxes $ ,

Lan69479_ch02_042-091.indd 53 31/10/18 10:54 AM

54 Part I Introduction and Overview

Exhibit 2.8

Cost of Goods

Manufactured and Sold

Statement for a

Manufacturing Firm

THREE RIVERS FABRICATION

Cost of Goods Manufactured and Sold Statement

For the Year Ending December 31, Year 2

($000)

Beginning work-in-process inventory, January 

............ $

Manufacturing costs during the year:

Direct materials:

Beginning inventory, January  ........................ $ 

Add purchases....................................... ,

Direct materials available............................$,

Less ending inventory, Dec.  ........................ 

Direct material put into production

................... $,

Direct labor............................................ ,

Manufacturing overhead ................................ ,

Total manufacturing costs incurred .....................

,

Total work

-in-process during the year ..................... $,

Less ending work-in-process inventory, December  ......

.............................



Cost of goods manufactured

$,

Beginning ﬁnished goods inventory, January .............

.........................



Finished goods available for sale $,

ess ending ﬁnished goods inventory, December  ....... ,

Cost of goods sold ..................................... $,

Cost of Goods Manufactured and Sold

We now demonstrate how to derive the cost of goods manufactured and sold amount on

the income statement from the company’s activities. The resulting statement is the cost of

goods manufactured and sold statement, which appears in Exhibit 2.8. You will be able to

see how these items appear in the cost of goods manufactured and sold statement if you

track each amount from the following example inExhibit 2.8.

Direct Materials

Assume the following for the company:

∙

Direct materials inventory on hand January 1 totaled $190,000.

∙

Materials purchased during the year cost $11,254,000.

∙

Ending inventory on December 31 was $144,000.

∙

Therefore, the cost of direct materials put into production during the year was

$11,300,000, com

puted as follows (in thousands of dollars).

.........................

.......................................

............................

....................

...........................

Beginning direct materials inventory, January  $  

Add purchases during the year ,

Direct materials available during the year $,

Less ending direct materials inventory, December  

Cost of direct materials put into production

$,

Work in Process

Consider the following:

∙

The Work-in-Process Inventory account had a beginning balance of $540,000 on

January 1, as shown in Exhibit 2.8.

Lan69479_ch02_042-091.indd 54 31/10/18 10:54 AM

Chapter 2 Cost Concepts and Behavior 55

∙

Exhibit 2.8 shows that costs incurred during the year totaled $11,300,000 in direct

materials (as shown in the preceding direct materials inventory schedule), $2,440,000

in direct labor costs, and $13,560,000 in manufacturing overhead. The sum of mate-

rials, labor, and manufacturing overhead costs incurred, $27,300,000, is the total

manufacturing costs incurred during the year. Managers in production and operations

give careful attention to these costs. Companies that want to be competitive in setting

prices must manage these costs diligently.

∙

From here on the process can seem complicated, but it’s not really so difficult if

you realize that accountants ar

e just adding and subtracting inventory values. In

other words, just as materials, in different forms, are moving from one inventory in

the plant to another, the costs in the cost accounting system are moving from one

inventory account to another. Adding the $540,000 beginning work-in-process

inventory to the $27,300,000 total manufacturing costs gives $27,840,000, the total

cost of work in process during the year. This is a measure of the resources that have

gone into production. Some of these costs were in the work-in-process inventory

on hand at the beginning of the period (that is, the $540,000 in beginning inven-

tory), but most have been incurred this year (that is, the $27,300,000 total manu-

facturing costs).

∙

At year-end, the work-in-process inventory has a $620,000 cost, which is subtracted

to arrive at t

he cost of goods manufactured during the year: $27,220,000

(= $27,840,000 − $620,000), which represents the cost of pumps and other products

finished during the year. Production departments usually have a goal for goods com-

pleted each period. Managers would compare the cost of goods manufactured to that

goal to see whether the production departments were successful in meeting it.

Finished Goods Inventory

The work finished during the period is transferred from the production department to the

finished goods storage area or is shipped to customers. If goods are shipped to customers

directly from the production line, no finished goods inventory exists. Three Rivers has a

finished goods inventory, however, because some of the products are common across

manufacturers and so it keeps some of them on hand to expedite orders. Here’s how the

amounts appear on the financial statements:

∙

Exhibit 2.8 shows that Three Rivers had $840,000 of finished goods inventory on

hand at the beginning of the year (January 1). F

rom the discussion about work in

process, we know that Three Rivers completed $27,220,000 worth of product, which

was transferred to finished goods inventory. Therefore, Three Rivers had $28,060,000

finished goods inventory available for sale, in total.

∙

Of the $28,060,000 available, Three Rivers had $1,860,000 finished goods still on

hand at the end of the year. This means t

hat the cost of goods sold was $26,200,000

(= $28,060,000 available − $1,860,000 in ending inventory).

Cost of Goods Manufactured and Sold Statement

As part of its internal reporting system, Three Rivers prepares a cost of goods manufac-

tured and sold statement (Exhibit 2.8). Such statements are for managerial use; you will

rarely see one published in external financial statements. Exhibit 2.8 incorporates and

summarizes information from the preceding discussion.

Manufacturing companies typically prepare a cost of goods manufactured and sold

statement to summarize and report manufacturing costs such as those discussed for Three

Rivers Fabrication, most often for managers’ use. Some companies have experimented

with preparing these statements for production workers and supervisors, who in some

cases have found them effective communication devices once these people learn how to

read them. For example, managers at Three Rivers use the cost of goods manufactured

and sold statement to communicate the size of manufacturing overhead and inventories to

stimulate creative ideas for reducing these items.

Lan69479_ch02_042-091.indd 55 31/10/18 10:54 AM

56 Part I Introduction and Overview

The cost of goods manufactured and sold statement in Exhibit 2.8 has three building

blocks. The first reports the cost of direct materials. Next is the work-in-process account

with its beginning balance, costs added during the period, ending balance, and cost of

goods manufactured. Third, the statement reports the beginning and ending finished

goods inventory and cost of goods sold.

These financial statements are presented in a standard format that you will find used

by many companies and on the CPA and CMA examinations. Please be aware that we

discuss many variations in this book, but many more exist in practice. For example, some

companies prepare separate statements of cost of goods sold and cost of goods manufac-

tured. It is important that financial statements effectively present the information that best

suits the needs of your customers or information users (for example, managers of your

company or your clients). For managerial purposes, it is important that the format of

financial statements be tailored to what users want (or to what you want if you are the

user of financial information).

Self-Study Questions

1. A review of accounts showed the following for Paciﬁc

Parts for last year.

Administrative costs ......................

...............

$,,

Depreciation, manufacturing ,

Direct labor .............................

,,

Direct materials purchases ................ ,,

Direct materials inventory, January  ....... ,

Direct materials inventory, December .... ,

Finished goods inventory, January ........ ,

Finished goods inventory, December  .... ,

Heat, light, and power—plant .............. ,

Marketing costs.......................... ,,

Miscellaneous manufacturing costs......... ,

(continued )

Plant maintenance and repairs............. ,

Sales revenue ........................... ,,

Supervisory and indirect labor ............. ,

Supplies and indirect materials ............ ,

Work-in-process inventory, January  ....... ,

Work-in-process inventory, December  ...

,

Prepare an income statement with a supporting cost of

goods manufactured and sold statement. Refer to Exhibits2.7

and 2.8.

2. Using the data from question 1, place dollar amounts in

each box in Exhibit 2.4.

The solutions to these questions are at the end of this chapter.

An Interim Debrief

Ingrid Jensen and Angela Berroa take a break from their

meeting. Ingrid summarizes what she has learned so far:

Learning the cost terms will really help me communi-

cate with both Angela and the ﬁnance sta at corpo-

rate. One important lesson I learned is that there are

dierent costs for dierent purposes. Financial report-

ing is important, but for the day-to-day management of

the plant, I am going to need more detailed cost

information.

I also have a better understanding of the dierent

types of costs. It really helped to see how these costs are

related to the production ﬂow; that’s something I under-

stand. I understand now why some of these costs are not

useful for managing the plant. For example, I know that for

any decision I might make, some of the costs—plant super-

vision, for example—are not likely to change. When Angela

returns, I am going to ﬁnd out how to identify the costs that

will be important for my decisions and how I can get the

cost information summarized in a way that helps me.

Lan69479_ch02_042-091.indd 56 31/10/18 10:54 AM

Chapter 2 Cost Concepts and Behavior 57

Manufacturing or Service: Not Always Clear

Business Application

Although we think of companies as either manufacturing or

service ﬁrms, the distinction is not always clear. This is espe-

cially true as technology is making it much less expensive for

manufacturers to monitor their customers’ use of the product.

Monitoring the use of an automobile or a piece of heavy equip-

ment, manufacturing ﬁrms use the information to sell additional

services. These might include upgrades to automobile sys-

tems over the Internet or repair services to companies whose

equipment is about to fail.

For example, Joy Global Inc., a unit of Komatsu Global, can

connect mining equipment to the company’s Smart Services

program, which monitors performance. Although only a rela-

tively small part of the business, “executives consider it a

growth business for a company where 65 percent of sales now

come from service and replacement parts, after soft markets for

mined commodities choked o demand for new equipment.”

Source:Tita, Bob, “Big Data Gives Manufacturers a New Revenue

Source,” Wall Street Journal, June 2, 2015.

Cost Behavior

The financial statements of Three Rivers Fabrication report what happened, but they fail to

show why. For that, we need to understand how costs behave and how managers analyze

costs to arrive at their decisions. Managerial decisions lead to the activities that the firm

undertakes, and these activities create (or destroy) the value in an organization. Informa-

tion from the cost accounting system is a key ingredient in making these decisions.

Cost behavior deals with the way costs respond to changes in activity levels. Through-

out this book, we refer to the idea of a cost driver. As defined in Chapter 1, a cost driver

is a factor that causes, or “drives,” costs. For example, the cost driver for the cost of lum-

ber for the activity of building a house could be the number of board feet of lumber used

or the size of the house in square feet. The cost driver for direct labor costs could be the

number of labor-hours worked.

Managers need to know how costs behave to make informed decisions about products,

to plan, and to evaluate performance. We classify the behavior of costs as being in one of

four basic categories: fixed, variable, semivariable, and step costs, as discussed next.

LO 25

Deﬁne basic cost

behaviors, including

ﬁxed, variable,

semivariable, and step

costs.

Fixed versus Variable Costs

Suppose that management contemplates a change in the volume of a company’s activity.

Some questions different managers might ask follow:

∙

An operations manager at United Airlines: How much will our costs decrease if we

reduce the number of flights by 5 percent?

∙

A manager at the U.S. Postal Service: Ho

w much will our costs decrease if we elimi-

nate Saturday deliveries?

∙

A business school dean: How muc

h will costs increase if we reduce average class size

by 10 students by increasing the number of classes offered?

To answer questions such as these, we need to know which costs are fixed costs that

remain unchanged as the volume of activity changes and which are variable costs that

change in direct proportion to the change in volume of activity.

ﬁxed costs

Costs that are unchanged as

volume changes within the

relevant range of activity.

variable costs

Costs that change in direct

proportion with a change in

volume within the relevant

range of activity.

If the activity is producing units, variable manu-

facturing costs typically include direct materials, cer-

tain manufacturing overhead (for example, indirect

materials, materials-handling labor, energy costs),

and direct labor in some cases (such as temporary

workers). Certain nonmanufacturing costs such as

distribution costs and sales commissions are typically

variable. Much of manufacturing overhead and many

nonmanufacturing costs are typically fixed costs.

For Air France, the cost of

executive salaries is ﬁxed.

The cost of fuel is variable

per hour or per mile ﬂown.

©Royalty-Free/Corbis

Lan69479_ch02_042-091.indd 57 31/10/18 10:54 AM

58 Part I Introduction and Overview

Exhibit 2.9 Four Cost Behavior Patterns

(a) (b) (c) (d)

Variable costs Fixed costs Semivariable costs Step costs

$$$$

Volume Volume Volume Volume

Although labor has traditionally been considered a variable cost, today the pro-

duction process at many firms is capital intensive, and the amount of labor required is

not sensitive to the amount produced. In a setting in which a fixed amount of labor is

needed only to keep machines operating, labor is probably best considered to be a

fixed cost.

In merchandising, variable costs include the cost of the product and some marketing

and administrative costs. All of a merchant’s product costs are variable. In manufactur-

ing, a portion of the product cost is fixed. In service organizations, variable costs typi-

cally include certain types of labor (such as temporary employees), supplies, and copying

and printing costs. Exhibit 2.9 depicts (a) variable cost behavior, and (b) fixed cost

behavior. Note in the graph that volume is on the horizontal axis, and total costs

(measured in dollars) are on the vertical axis. Item (a) shows that total variable costs

increase in direct proportion to changes in volume. Thus, if volume doubles, total vari-

able costs also double. Item (b) shows that fixed costs are at a particular level and do not

increase as volume increases.

The identification of a cost as fixed or variable is valid only within a certain range of

activity. For example, the manager of a restaurant in a shopping mall increased the capac-

ity from 150 to 250 seats, requiring an increase in rent costs, utilities, and many other

costs. Although these costs are usually thought of as fixed, they change when activity

moves beyond a certain range. This range within which the total fixed costs and unit vari-

able costs do not change is called the relevant range.

relevant range

Activity levels within which a

given total ﬁxed cost or unit

variable cost will be

unchanged.

Four aspects of cost behavior complicate the task of classifying costs into fixed and

variable categories. First, not all costs are strictly fixed or variable. For example, electric

utility costs may be based on a fixed minimum monthly charge plus a variable cost for

each kilowatt-hour. Such a semivariable cost has both fixed and variable components.

Semivariable costs, also called mixed costs, are depicted in Exhibit 2.9 (c).

semivariable cost

Cost that has both ﬁxed and

variable components; also

called mixed cost.

Second, some costs increase with volume in “steps.” Step costs, also called semifixed

costs, increase in steps as shown in Exhibit 2.9 (d). For example, one supervisor might be

needed for up to four firefighters in a fire station, two supervisors for five to eight, and so

forth as the number of firefighters increases. The supervisors’ salaries represent a step cost.

step cost

Cost that increases with

volume in steps; also called

semiﬁxed cost.

Third, as previously indicated, the cost relations are valid only within a relevant range

of activity. In particular, costs that are fixed over a small range of activity are likely to

increase over a larger range of activity.

Finally, the classification of costs as fixed or variable depends on the measure of

activity used. For example, at Three Rivers, part of the production cost is setting up the

machines to run a specific part. Plant engineers have to calibrate the machine for each

production run, but each run can produce up to 4,000 parts. If production volume is the

activity measure, then the plant engineer costs are a step cost. However, if the number of

production runs is the activity measure, then the plant engineer costs are variable; they

spend the same amount of time for each run.

Understanding cost behavior is an important part of using cost accounting informa-

tion wisely for decisions. Consider a recent example at Three Rivers. Calumet Tractors, a

Lan69479_ch02_042-091.indd 58 31/10/18 10:54 AM

Chapter 2 Cost Concepts and Behavior 59

Exhibit 2.10

Cost Data for Price

Quotation

Cost Item Amount Notes

Develop production speciﬁcations for

This is a one-time expenditure

for drawings.

Direct materials (metal) This is the cost per pump.

Direct labor This is the cost per pump.

Set-up machinery

in a single production run.

Inspect pumps: Equipment A new measuring device is required.

Labor Per pump.

longtime customer of Three Rivers, has requested a price quotation from Three Rivers for

a modified version of a common water pump. The modified pump is the CT-24SF.

Calumet wants the quotation to cover a volume of CT-24SF pumps from 4,000 to 7,500,

because it is not sure of its final requirement.

Angela Berroa, the plant controller, has prepared the preliminary cost data in Exhibit 2.10

for Mark Mays, the Three Rivers sales representative f

or Calumet. The cost for develop-

ing production specifications is fixed. It does not depend on the volume of pumps actu-

ally produced. The direct materials and the direct labor costs are variable. They increase

proportionately with volume.

The cost for setting up the machinery is neither fixed nor variable with respect to v olume.

The setup costs are semifixed—they are incurred to se

t up the initial production run, and then

they are not affected by production until 5,000 pumps have been produced. To pr oduce more

than 5,000 pumps, another fixed amount must be spent. The inspection costs are semivari-

able. The new measuring device is a fixed cost and the $0.25 per part is variable.

Components of Product Costs

We have now seen that various concepts of costs exist. Some are determined by the rules

of financial accounting. Some are more useful for managerial decision making. In this

section, we develop several diagrams to explain various cost concepts and identify the

differences.

Starting with Exhibit 2.11, assume that Three Rivers Fabrication estimates the cost to

produce a specialized tractor pump during year 3. The full cost to manufacture and sell

one pump is estimated to be $40, as shown on the left side of Exhibit 2.11. The unit cost

of manufacturing the pump is $29, also shown on the left side of the exhibit. (One unit is

one pump.) This full cost of manufacturing the one unit is known as the full absorption

cost. It is the amount of inventoriable cost for external financial reporting according to

GAAP. The full absorption cost “fully absorbs” the variable and fixed costs of manufac-

turing a product.

LO 2-6

Identify the components

of a product’s cost.

full cost

Sum of all ﬁxed and variable

costs of manufacturing and

selling a unit.

full absorption cost

All variable and ﬁxed

manufacturing costs; used to

compute a product’s inventory

value under GAAP.

The full absorption cost excludes nonmanufacturing costs, however, so marketing

and administrative costs are not inventoriable costs. These nonmanufacturing costs equal

$11 per unit, which is the sum of the two blocks at the bottom of Exhibit 2.11.

The variable costs to make and sell the product are variable manufacturing costs, $23

per unit, and variable nonmanufacturing costs, $4 per unit. Variable nonmanufacturing

costs could, in general, be either administrative or marketing costs. For Three Rivers,

variable nonmanufacturing costs are primarily selling costs. In other cases, variable

administrative costs could include costs of data processing, accounting, or any adminis-

trative activity that is affected by volume.

Exhibit 2.11 also includes unit fixed costs. The unit fixed costs are valid only at one

volume—2,000 units (of this pump) per year—for Three Rivers. By definition, total fixed

costs do not change as volume changes (within the relevant range, of course). Therefore,

a change in volume results in a change in the unit fixed cost, as demonstrated by Self-

Study Question 3.

Lan69479_ch02_042-091.indd 59 16/11/18 1:09 PM

60 Part I Introduction and Overview

Exhibit 2.11

Product Cost

Components—Three

Rivers Fabrication

Direct materials

Full cost

per

unit

$40

Unit

variable

cost

Variable

manufacturing

cost

$23

Variable

marketing and

administrative

costs

Full

absorption

cost per

unit

$29

Variable manufacturing

overhead

Fixed manufacturing

overhead

(

$12,000 2,000 units)

Variable marketing and

administrative

costs

Direct labor

Fixed marketing and

administrative costs

(

$14,000 2,000 units)

Unit Fixed Costs Can Be Misleading for Decision Making

When analyzing costs for decisions, you should use unit fixed costs very carefully. Many

managers fail to realize that they are valid at only one volume. When fixed costs are allo-

cated to each unit, accounting records often make the costs appear as though they are vari-

able. For example, allocating some of factory rent to each unit of product results in including

rent as part of the “unit cost” even though the total rent does not change with the manufac-

ture of another unit of product. Cost data that include allocated common costs therefore

may be misleading if used incorrectly. The following example demonstrates the problem.

One of the parts Three Rivers sells has a unit manufacturing cost of $2.80 ($1.50 per

unit variable manufacturing cost + $1.30 per unit fixed manufacturing cost), computed as

follows (each part is one unit).

Variable manufacturing costs per unit ................................... $1.50

Fixed manufacturing costs:

Fixed manufacturing cost per month $130,000

Unit cost = = =

Units produced per month 100,000 units

1.30

Total unit cost used as the inventory value for

external ﬁnancial reporting .........................................

. $2.80

Lan69479_ch02_042-091.indd 60 16/11/18 2:27 PM

Chapter 2 Cost Concepts and Behavior 61

Three Rivers received a special order for 10,000 parts at $2.75 each. These units

could be produced with currently idle capacity. Marketing, administrative, and the total

fixed manufacturing costs of $130,000 would not be affected by accepting the order, nor

would accepting this special order affect the regular market for this part.

Marketing managers believed the special order should be accepted as long as the unit

price of $2.75 exceeded the cost of manufacturing each unit. When the marketing manag-

ers learned from accounting reports that the inventory value was $2.80 per unit, their

initial reaction was to reject the order because, as one manager stated, “We are not going

to be very profitable if our selling price is less than our production cost!”

Fortunately, some additional investigation revealed the variable manufacturing cost

to be only $1.50 per unit. Marketing management accepted the special order, which had

the following impact on the company’s operating profit.

Revenue from special order (, units × $.) . . . . . . . . . . . . . . . . . . . . .

............

......................

$,

Variable costs of making special order (, units × $.) ,

Contribution of special order to operating proﬁt $,

The moral of this example is that it is easy to interpret unit costs incorrectly and

make incorrect decisions. In this example, fixed manufacturing overhead costs had been

allocated to units, most likely to value inventory for external financial reporting and tax

purposes. The resulting $2.80 unit cost appeared to be the cost to produce a unit. Of

course, only $1.50 was a per unit variable cost; the $130,000 per month fixed cost would

not be affected by the decision to accept the special order.

Self-Study Question

3. Refer to the Three Rivers example in Exhibit 2.11 that is

based on a volume of 2,000 units per year. Assume the

same total ﬁxed costs and unit variable costs but a vol-

ume of only 1,600 units. What are the ﬁxed manufacturing

costs per unit and the ﬁxed marketing and administrative

costs per unit?

The solution to this question is at the end of this chapter.

Exhibits 2.12 and 2.13 are designed to clarify definitions of gross margin, contribu-

tion margin, and operating profit. You may recall from your study of financial accounting

statements that the gross margin appears on external financial statements as the differ-

ence between revenue and cost of goods sold. We refer to this format as a traditional

income statement. Cost of goods sold is simply the full absorption cost per unit times the

number of units sold. Exhibit 2.12 presents the gross margin per unit for the pumps that

Three Rivers produces and sells for $45 each.

gross margin

Revenue – Cost of goods sold

on income statements. Per unit,

the gross margin equals Sales

price – Full absorption cost

per unit.

Recall from Exhibit 2.11 that each pump is estimated to have a $29 full absorption

cost. Therefore, the gross margin per unit is $16 (= $45 − $29). The operating profit

per unit is the difference between the sales price and the full cost of making and selling

the product. For Three Rivers, Exhibit 2.12 shows the operating profit per unit to be $5

(= $45 sales price − $40 full cost).

Exhibit 2.13 also shows the contribution margin per unit. On a per unit basis, the

contribution margin is the difference between the sales price and the variable cost per unit.

Think of the contribution margin as the amount available to cover fixed costs and earn a profit.

contribution margin

Sales price – Variable costs

per unit.

The contribution margin is important information for managers because it allows

them to assess the profitability of products before factoring in fixed costs (which tend to

be more difficult to change in the short run). For example, a coffee shop sells both drip

coffee and espresso drinks. A cup of drip coffee sells for $1.50 and a cappuccino sells for

$2.50. Which product contributes more per unit to profits? Answer: We don’t know until

we know the contribution margin per unit for each product. Suppose that the variable cost

Lan69479_ch02_042-091.indd 61 31/10/18 10:55 AM

62 Part I Introduction and Overview

Exhibit 2.12

Gross Margin per

Unit—Three Rivers

Fabrication

Variable manufacturing

cost

$23

Full

cost per

unit

$40

Operating proﬁt

Sales price

per

unit

$45

Full

absorption

cost per

unit

$29

Gross margin

$16

($45

–

$29)

Fixed manufacturing

cost

Variable marketing and

administrative

Fixed marketing and

administrative

Excess of price over full

unit cost

Sales price

per

unit

$45

per cup is $0.25 for drip coffee and $1.50 for cappuccino. Then the contribution margins

(per unit) are as follows:

∙

Drip coffee $1.25 (= $1.50 sales price − $0.25 variable cost).

∙

Cappuccino $1.00 (= $2.50 sales price − $1.50 variable cost).

∙

Although the cappuccino sells for more, the drip coffee provides a higher contribu-

tion per unit toward covering fixed costs and earning a profit.

Self-Study Questions

Refer to the Three Rivers examples in Exhibits 2.12

and 2.13.

4. Assume that the variable marketing and administrative

cost falls to $3 per unit; all other cost numbers remain the

same. What are the new gross margin, contribution mar-

gin, and operating proﬁt amounts?

5. Assume that the ﬁxed manufacturing cost dropped from

$12,000 to $10,000 in total, or from $6 to $5 per unit. All

other unit cost numbers remain the same as in Exhibits 2.12

and 2.13. What are the new gross margin, contribution

margin, and operating proﬁt amounts?

The solutions to these questions are at the end of the chapter.

Lan69479_ch02_042-091.indd 62 31/10/18 10:55 AM

Chapter 2 Cost Concepts and Behavior 63

Exhibit 2.13

Contribution Margin per

Unit—Three Rivers

Fabrication

Variable manufacturing

cost

$23

Full

cost per

unit

$40

Operating

proﬁt

Sales price

per

unit

$45

Variable

cost per

unit

$27

Contribution

margin

$18

($45

–

$27)

Variable marketing and

administrative

Fixed manufacturing

cost

Fixed marketing and

administrative

Excess of price over full

unit cost

Sales price

per

unit

$45

How to Make Cost Information More Useful for Managers

As discussed earlier, cost accountants divide costs into product or period categories. In

general, product costs are more easily attributed to products; period costs are more easily

attributed to time intervals. Once product costs are defined, all other costs are assumed to

be period costs. It is important to note, however, that the determination of product costs

varies, depending on the approach used. Three common approaches are outlined here:

∙

Full absorption costing (traditional income statement). Under this approach required

by GAAP, all fixed and variable manufacturing costs are product costs. All other

costs are period costs.

∙

Variable costing (contribution margin income statement). Using this approach, only

variable manufacturing costs are product costs. All other costs are period costs.

∙

Managerial costing. This approach assumes that management determines which

costs are associated with the product and should be considered product costs. Man-

agement asks whether adding a product will incur new costs. Any new costs are

considered product costs. For example, management could decide that promotional

LO 27

Understand the distinc-

tion between ﬁnancial

and contribution margin

income statements.

Lan69479_ch02_042-091.indd 63 31/10/18 10:55 AM

64 Part I Introduction and Overview

campaigns associated with a new product are product costs. Under the other two

approaches, promotional costs would be period costs. Clearly, the managerial costing

approach to defining product costs is subjective and depends on management’s use of

cost information.

Gross Margin versus Contribution Margin Income Statements

A traditional income statement using full absorption costing (the first approach in the list)

and a contribution margin income statement using variable costing (the second approach)

for a special order of pumps are shown in Exhibit 2.14. The data come from Exhibits 2.12

and 2.13, but unit costs are multiplied by 2,000 pumps to give total amounts for year 3.

Operating profit is the same for each approach because total units produced equal total

units sold, but note the difference in product costs on each statement. We do not provide

an income statement example for the third approach (managerial costing) because the

treatment of product costs using this approach varies from one company to the next.

Product costs for units not yet sold are assigned to inventory and carried in the

accounts as assets. When the goods are sold, the costs flow from inventory to the income

statement. At that time, these previously inventoried costs become expenses.

Developing Financial Statements for Decision Making

While the gross margin and contribution margin statements illustrated in Exhibit 2.14 are

common, there is no reason to restrict managers to these statements. The goal of the cost

accounting system is to provide managers with information useful for decision making. In

designing the cost accounting system, we determine the information that managers use in

making decisions and then provide it to them in ways that support their work.

For example, many firms are concerned with ensuring that the activities they under-

take add value to their product or service. If this is important to managers for making

decisions, we can develop financial statements that classify costs into value-added or

nonvalue-added categories. By classifying activities as value added or nonvalue added,

managers are better able to reduce or eliminate nonvalue-added activities and therefore

reduce costs.

Suppose that Ingrid Jensen, the plant manager of Three Rivers, wants to know which

costs add value in the case of the special order. The controller reviews production activi-

ties and related costs in detail for the order and prepares the value income statement

shown in Exhibit 2.15. The data come from Exhibit 2.14. However, costs are shown in

greater detail and separated into nonvalue-added and value-added categories. For exam-

ple, variable marketing and administrative costs of $8,000 from Exhibit 2.14 are shown as

two line items under variable marketing and administrative costs in Exhibit 2.15: market-

ing and administrative services used to sell products totaling $6,000 and marketing and

Exhibit 2.14 Gross Margin versus Contribution Margin Income Statements

Gross Margin Income Statement Contribution Margin Income Statement

Sales revenue

......................... $,

Sales revenue

$,

Variable manufacturing costs .......... , Variable manufacturing costs ,

Fixed manufacturing costs

.............

, Variable marketing and

administrative costs ,

Gross margin

.......................... $,

Contribution margin

.. $,

Variable marketing and

administrative costs

................ ,

Fixed manufacturing costs .. ,

Fixed marketing and

administrative costs ................ ,

Fixed marketing and

administrative costs ,

Operating proﬁt

........................ $,

.........................

..........

................

..................

...........

................

Operating proﬁt

........................ $,

Lan69479_ch02_042-091.indd 64 31/10/18 10:55 AM

Chapter 2 Cost Concepts and Behavior 65

Exhibit 2.15 Value Income Statement

THREE RIVERS FABRICATION

Value Income Statement Special Order

For the Year Ending December 31, Year 3

Nonvalue-Added

Activities

Value-Added

Activities Total

Sales revenue................................................ $, $,

Variable manufacturing costs

Materials used in production ................................. , ,

Materials waste ............................................ $ , ,

Labor used in production .................................... , ,

Labor used to rework products............................... , ,

Manufacturing overhead used in production ................... , ,

Manufacturing overhead used to rework products . . . . . . . . . . . . . .  

Variable marketing and administrative costs

Marketing and administrative services used to sell products ..... , ,

Marketing and administrative services used to process

returned products .......................................... , ,

Contribution margin........................................... $(,)

$, $,

Fixed manufacturing

Fixed manufacturing costs used in production..................

, ,

Salaries of employees reworking products..................... , ,

Fixed marketing and administrative costs

Marketing and administrative services used to sell products ..... , ,

Marketing and administrative services used to process

returned products ..........................................  

Operating proﬁt (loss) ......................................... $(,) $, $,

Lan69479_ch02_042-091.indd 65 31/10/18 10:55 AM

administrative services used to process returned products totaling $2,000. The value

income statement outlines costs linked to three segments of the value chain: production,

marketing, and distribution. Remember that the primary idea of the value chain is that

value is added to the product in each business function. The goal is to maximize value-

added activities and minimize nonvalue-added activities.

The controller identifies nonvalue-added activities associated with two areas—

materials waste and reworked products. Materials waste refers to material that was thrown

away because of incorrect cuts or defective material. Reworked products consist of prod-

ucts that have been manufactured incorrectly (for example, incorrect pump size or num-

ber of teeth) and have to be fixed (or reworked). Costs to rework products are generally

incurred by the production, marketing, and administration departments. Marketing gets

involved because failure detection sometimes does not occur until the customer returns

the goods. Thus, nonvalue-added activities are not limited to production.

Assume that the company sold 2,000 units in year 3, and the controller uses the per

unit costs outlined in Exhibit 2.13. The controller’s value income statement shows total

nonvalue-added activities to be $8,000. This amount is only 10 percent of total costs but

is 80 percent of operating profit. Clearly, reducing nonvalue-added activities could sig-

nificantly increase profits.

Reducing nonvalue-added activities is not a simple task. For example, how should

the production process be changed to reduce materials waste? Should higher-quality

materials be purchased, resulting in higher direct materials costs? Or should production

personnel be trained and evaluated based on materials wasted? However, providing the

information highlights the problem and the potential effect that changes could have on

firm performance. Depending on the business and strategic environment of the firm, we

could construct financial statements around activities related to quality, environmental

compliance, or new product development.

66 Part I Introduction and Overview

The Debrief

Ingrid Jensen studied the value income statement (Exhibit 2.15)

and commented:

This is exactly the type of information I need to manage

the plant. It is clear that one of my ﬁrst priorities has to be

improving quality. With the traditional ﬁnancial statements

I would not have seen the opportunity for increasing value.

My production supervisor and I were aware, of course,

that we had some waste associated with scrap and

rework, but until we put a value on it I wasn’t sure how

important a problem it was. When we get that additional

manufacturing back here, we will have a much better

chance of keeping it here.

SUMMARY

The term cost is ambiguous when used alone; it has meaning only in a specific context. The

adjectives used to modify cost constitute that context. Exhibit 2.16 summarizes definitions of

the word. It is important to consider how the use of these terms in cost accounting differs

from common usage. For example, in common usage, a variable cost may vary with anything

(geography, temperature, and so forth). In cost accounting, variable cost depends solely on

volume.

Exhibit 2.16

Summary of Cost Terms

and Deﬁnitions

Nature of Cost

Cost ................................... A sacriﬁce of resources.

Opportunity cost ................ The forgone beneﬁt from the best (forgone) alternative

course of action.

Outlay cost ........................ A past, present, or future cash outﬂow.

Expense ............................ A cost that is charged against revenue in an accounting

period.

Cost Concepts for Cost Accounting Systems

Product cost ...................... Cost that can be attributed to a product.

Period cost ........................ Cost that can be attributed to time intervals.

Full absorption cost ........... All variable and ﬁxed manufacturing costs; used to compute

a product’s inventory value under GAAP.

Direct cost

......................... Cost that can be directly (unambiguously and at low cost)

related to a cost object.

Indirect cost ....................... Cost that cannot be directly related to a cost object.

Cost Concepts for Describing Cost Behavior

Variable cost ...................... Cost that changes in direct proportion with a change in

volume within the relevant range of activity.

Fixed cost .......................... Cost that is unchanged as volume changes within the

relevant range of activity .

The following summarizes key ideas tied to the chapter’s learning objectives.

LO 2-1 Explain the basic concept of “cost.” A cost is a sacrifice of resources, and an

expense is a cost char

ged against revenue in an accounting period, typically for external

reporting purposes.

Lan69479_ch02_042-091.indd 66 31/10/18 10:55 AM

Chapter 2 Cost Concepts and Behavior 67

LO 2-2 Explain how costs are presented in financial statements. Cost of goods sold in a

merchandising organization simply includes the costs of purchase and incoming trans-

portation of the goods. Cost of goods sold for manufacturing organizations is much

more complicated and includes direct materials (raw materials), direct labor, and manu-

facturing overhead. Cost of goods (i.e., services) sold in a service organization primarily

includes labor and overhead.

LO 2-3

Explain the process of cost allocation. Cost allocation is required to assign, or allo-

cate, costs recorded in various accounts (the cost pools) to the cost objects (product,

department, customer) of interest. An allocation rule specifies how this is done because

there is generally no economically feasible way of associating the costs directly with the

cost objects.

LO 2-4

Understand how materials, labor, and overhead costs are added to a product at each

stage of the production process. Manufacturing organizations have three stages of pro-

duction: direct materials, work in process, and finished goods. All items not sold at the

end of the period are included in inventory as an asset on the balance sheet. All finished

goods sold at the end of the period are included as cost of goods sold in the income

statement.

LO 2-5

Define basic cost behaviors, including fixed, variable, semivariable, and step costs.

Cost behavior can be classified in one of four ways: fixed, variable, semivariable, or

step costs.

LO 2-6 Identify the components of a product’s costs.



Variable cost per unit.



Full absorption cost per unit, which is the inventoriable amount under GAAP.



Full cost per unit of making and selling the product.



Gross margin, which equals sales price minus full absorption cost.



Contribution margin, which equals sales price minus variable cost.



Profit margin, which equals sales price minus full cost.

LO 2-7

Understand the distinction between financial and contribution margin income

statements. The traditional income statement format is used primarily for external

reporting purposes, and the contribution margin income statement format is used

more for internal decision-making and performance evaluation purposes. A third

alternative is the value approach, which categorizes costs into value- and nonvalue-

added activities.

KEY TERMS

administrative costs, 49

contribution margin, 61

conversion costs, 49

cost, 44

cost allocation, 50

cost allocation rule, 51

cost flow diagram, 51

cost object, 50

cost of goods sold, 48

cost pool, 51

direct cost, 51

direct labor, 48

direct manufacturing

costs, 48

direct materials, 48

expense, 44

finished goods, 52

fixed costs, 57

full absorption cost, 59

full cost, 59

gross margin, 61

indirect cost, 51

indirect manufacturing

costs, 48

inventoriable costs, 52

manufacturing overhead, 49

marketing costs, 49

operating profit, 45

opportunity cost, 44

outlay cost, 44

period costs, 48

prime costs, 49

product costs, 48

relevant range, 58

semivariable cost, 58

step cost, 58

variable costs, 57

work in process, 52

Lan69479_ch02_042-091.indd 67 31/10/18 10:55 AM

68 Part I Introduction and Overview

REVIEW QUESTIONS

2-1. What is the difference in meaning between the terms cost and expense?

2-2. What is the difference between product costs and period costs?

2-3. What is the difference between outlay cost and opportunity cost?

2-4. Provide a business example illustrating opportunity costs.

2-5. Is “cost-of-goods sold” an expense?

2-6. Is “cost-of-goods” a product cost or a period cost?

2-7. What are the similarities between the Direct Materials Inventory account of the manufac-

turer and the Merchandise Inventory account of the merchandiser? Are there any differ-

ences between the two accounts? If so, what are they?

2-8. What are the three categories of product cost in a manufacturing operation? Describe each

element briefly.

2-9. What is the difference between gross mar gin and contribution margin?

2-10.

To a manager making a decision, which is likely more important: gross margin or contri-

bution margin? Why?

2-11.

What do the terms step costs and semivariable costs mean?

2-12.

What do the terms variable costs and fixed costs mean?

2-13.

How does a value income statement differ from a gross margin income statement? From a

contribution margin income statement?

2-14.

Why is a value income statement useful to managers?

CRITICAL ANALYSIS AND DISCUSSION QUESTIONS

2-15. “Materials and labor are always direct costs, and supply costs are always indirect.” What is

your opinion of this statement?

2-16. The cost per seat-mile for a major U.S. airline is 14.1 c

⁄

. Therefore, to estimate the cost of

flying a passenger from Detroit to Los Angeles, we should multiply 1,980 miles by 14.1 c

⁄

Do you agree? Explain.

2-17.

In evaluating product profitability, we can ignore marketing costs because they are not

considered product costs. Do you agree?

2-18.

You and two friends drive your car to Texas for spring break. A third friend asks if you can

drop her off in Oklahoma. How would you allocate the cost of the trip among the four of

you?

2-19.

The friend in question 2-18 decides that she does not want to go to Oklahoma after all.

How will the costs of your trip change? Was your choice of allocation in question 2-18

incorrect? Why?

2-20.

Consider a digital music service such as those provided by Amazon or Apple. What are

some of the major cost categories? Are they mostly fixed or mostly variable?

2-21.

Consider a ride-sharing service such as Uber or Lyft. What are some of the major cost

categories? Are they mostly fixed or mostly variable? How are the costs different from

those incurred by the drivers?

2-22.

Pick a unit of a hospital (for example, intensive care or maternity). Name one example of a

direct materials cost, one example of a direct labor cost, and one example of an indirect

cost.

2-23.

The dean of Midstate University Business School is trying to understand the costs of the

school’s two degree programs: Bachelor’s (BBA) and Master’s (MBA). She has asked you

for recommendations on how to allocate the costs of the following services, which are used

by students in both programs: cafeteria, library, and career placement. How would you

respond?

2-24.

Currently, generally accepted accounting principles (GAAP) in the United States require

firms to expense research and development (R&D) costs as period costs. Therefore, when

the resulting product is sold, R&D costs are not part of reported product costs. Does this

mean that R&D costs are irrelevant for decision making?

2-25.

If value income statements are useful for decision making, why are value income state-

ments not used in financial reporting?

Lan69479_ch02_042-091.indd 68 31/10/18 10:55 AM

Lan69479_ch02_042-091.indd 69 31/10/18 10:55 AM

Chapter 2 Cost Concepts and Behavior 69

All applicable Exercises are included in Connect. EXERCISES

2-26. Basic Concepts

(LO 2-1, 5)

For each of the following statements, indicate whether it is true, false, or uncertain. Explain why.

Give examples in your answer.

A cost is something used up to produce revenues in a particular accounting period.

b. Variable costs are direct costs; only fixed costs are indirect costs.

c. The cost of direct materials is fixed per unit but variable in total.

2-27. Basic Concepts

(LO 2-1, 5)

For each of the following costs incurred in a manufacturing firm, indicate whether the costs are

most likely fixed (F) or variable (V) and whether they are most likely period costs (P) or product

costs (M) under full absorption costing.

a. Depreciation on the building for administrative staff offices.

b. Cafeteria costs for the factory.

c. Overtime pay for assembly workers.

d. Transportation-in costs on materials purchased.

e. Salaries of top executives in the company.

f. Sales commissions for sales personnel.

g. Assembly line workers’ wages.

h. Controller’s office rental.

i. Administrative support for sales supervisors.

j. Energy to run machines producing units of output in the factory.

2-28. Basic Concepts

(LO 2-1, 2)

For each of the following costs incurred in a manufacturing operation, indicate whether they are

included in prime costs (P), conversion costs (C), or both (B).

Assembly line worker’s salary.

b. Direct materials used in the production process.

c. Property taxes on the factory.

d. Lubricating oil for plant machines.

e. Transportation-in costs on materials purchased.

2-29. Basic Concepts

(LO 2-1, 2, 5)

Place the number of the appropriate definition in the blank next to each concept.

Concept Deﬁnition

Period cost 1. Sacriﬁce of resources.

Indirect cost 2. Cost that cannot be directly related to a cost object.

Fixed cost 3. Cost that varies with the volume of activity.

Opportunity cost 4. Cost used to compute inventory value according to GAAP.

Outlay cost 5. Cost charged against revenue in a particular accounting period.

Direct cost 6. Cost that can be directly related to a cost object.

Expense 7. Past, present, or near-future cash ﬂow.

Cost 8. Lost beneﬁt from the best forgone alternative.

Variable cost 9. Cost that can more easily be attributed to time intervals.

Full absorption cost 10. Cost that does not vary with the volume of activity.

Product cost 11. Cost that is part of inventory.

70 Part I Introduction and Overview

(LO 2-1, 6)

2-30. Basic Concepts: Multiple Choice

Michael’s Machine Shop r eports the following information for the quarter.

Sales price .................................................................................................................... $ 

Fixed costs (for the quarter)

Selling and administration ................................................................................... ,

Production ................................................................................................................ ,

Variable cost (per unit)

Materials ................................................................................................................... 

Labor.......................................................................................................................... 

Plant supervision.................................................................................................... 

Selling and administrative .................................................................................... 

Number of units (for the quarter) ............................................................................ , units

Required

Select the answer for each of the following costs.

a. Variable cost per unit.

$32

$21

$26

$23

b. Variable production cost per unit.

$32

$21

$26

$23

c. Full cost per unit.

$29

$34

$32

$36

d. Full absorption cost per unit.

$29

$34

$32

$36

e. Prime cost per unit.

$12

$21

$11

f. Conversion cost per unit.

$11

$17

$19

$14

g. Contribution margin per unit.

$11

$14

$17

$19

h. Gross margin per unit.

$17

$14

$11

Lan69479_ch02_042-091.indd 70 31/10/18 10:55 AM

Chapter 2 Cost Concepts and Behavior 71

2-31. Basic Concepts: Multiple Choice (LO 2-1, 6)

The following information is available for Henderson Components for the year just ended.

Sales price ................................................................................................................. $ 

Fixed costs (for the year)

Selling and administrative ................................................................................. ,

Production ............................................................................................................. ,

Variable cost (per unit)

Materials ................................................................................................................ 

Labor....................................................................................................................... 

Plant supervision ................................................................................................. 

Selling and administrative ................................................................................. 

Number of units (for the year) .............................................................................. , units

Required

Select the answer for each of the following costs.

a. Variable cost per unit.

$12

$13

$16

$18

b. Variable production cost per unit.

$12

$13

$16

$18

c. Full cost per unit.

$13

$15

$16

$23

d. Full absorption cost per unit.

$13

$15

$16

$23

e. Prime cost per unit.

$12

$13

$16

f. Conversion cost per unit.

$10

$12

$16

g. Contribution margin per unit.

$11

$14

h. Gross margin per unit.

$11

$14

Lan69479_ch02_042-091.indd 71 31/10/18 10:55 AM

72 Part I Introduction and Overview

(LO 2-1, 5)

2-32. Basic Concepts

For each of the following costs incurred in a manufacturing firm, indicate whether the costs are

fixed (F) or variable (V) and whether they are period costs (P) or product costs (M) under full

absorption costing.

a. Power to operate factory equipment.

b. Chief financial officer’s salary.

c. Commissions paid to sales personnel.

d. Office supplies for the human resources manager.

e. Depreciation on pollution control equipment in the plant.

(LO 2-1, 2, 6)

2-33. Basic Concepts

The following data apply to the provision of psychological testing services.

Sales price per unit ( unit =  test plus feedback to client) ........................... $ 

Fixed costs (per month):

Selling and administration .................................................................................... ,

Production overhead (e.g., rent of testing facilities) ...................................... ,

Variable costs (per test):

Labor for oversight and feedback ...................................................................... 

Outsourced test analysis ....................................................................................... 

Materials used in testing ....................................................................................... 

Production overhead ............................................................................................. 

Selling and administration (e.g., scheduling and billing)............................... 

Number of tests per month ....................................................................................... , tests

Required

Give the amount for each of the following (one unit = one test):

a. Variable production cost per unit.

b. Variable cost per unit.

c. Full cost per unit.

d. Full absorption cost per unit.

e. Prime cost per unit.

f. Conversion cost per unit.

g. Contribution margin per unit.

h. Gross margin per unit.

i. Suppose the number of units decreases to 1,250 tests per month, which is within the relevant

range. Which parts of (a) through (h) will change? For each amount that will change, give the

new amount for a volume of 1,250 tests.

(LO 2-1, 2, 6)

2-34. Basic Concepts

Intercontinental, Inc., provides you with the following data for its single product.

Sales price per unit ..................................................................................................... $ 

Fixed costs (per month):

Selling, general, and administrative (SG&A) .................................................... ,,

Manufacturing overhead ....................................................................................... ,,

Variable costs (per unit):

Direct labor ............................................................................................................... 

Direct materials........................................................................................................ 

Manufacturing overhead....................................................................................... 

SG&A .......................................................................................................................... 

Number of units produced per month ................................................................... , units

Lan69479_ch02_042-091.indd 72 31/10/18 10:55 AM

Chapter 2 Cost Concepts and Behavior 73

Required

Give the amounts for each of the following:

a. Prime cost per unit.

b. Contribution margin per unit.

c. Gross margin per unit.

d. Conversion cost per unit.

e. Variable cost per unit.

f. Full absorption cost per unit.

g. Variable production cost per unit.

h. Full cost per unit.

i. Suppose the number of units increases to 400,000 units per month, which is within the rele-

vant range. Which of amounts (a) through (h) will change? For each that will change, give the

new amount for a volume of 400,000 units.

2-35. Cost Allocation—Ethical Issues

(LO 2-3)

In one of its divisions, an aircraft components manufacturer produces experimental navigational

equipment for spacecraft and for private tr

ansportation companies. Although the products are

essentially identical, they carry different product numbers. The XNS-12 model is sold to a govern-

ment agency on a cost-reimbursed basis. In other words, the price charged to the government is

equal to the computed cost plus a fixed fee. The JEF-3 model is sold to the private transportation

companies on a competitive basis. The product development cost, common to both models, must

be allocated to the two products in order to determine the cost for setting the price of the XNS-12.

Required

a. How would you recommend the product development cost be allocated between the two products?

b. What incentives do managers have to allocate product development costs? Why?

2-36. Cost Allocation—Ethical Issues (LO 2-3)

Star Buck, a coffee shop manager, has two major product lines—drinks and pastries. If Star allocates

common costs on any objective basis discussed in this chapter, the drinks are profitable, but the pas-

tries are not. Star is concerned that her boss will pull the plug on pastries. Star’s brother, who is strug-

gling to make a go of his new business, supplies pastries to the coffee shop. Star decides to allocate all

common costs to the drinks because “Drinks can afford to absorb these costs until we get the pastries

line on its feet.” After assigning all common costs to drinks, both the drinks and pastries product lines

appear to be marginally profitable. Consequently, Star’s manager decides to continue the pastries line.

Required

a. How would you recommend Star allocate the common costs between drinks and pastries?

b. You are the assistant manager and have been working with Star on the allocation problem.

What should you do?

2-37. Prepare Statements for a Manufacturing Company (LO 2-2, 4)

The following balances are from the accounts of Tappan Parts.

January  (Beginning) December  (Ending)

Direct materials inventory ................... $ , $ ,

Work-in-process inventory .................. ,, ,,

Finished goods inventory.................... , ,

Direct materials used during the year amount to $1,196,000 and the cost of goods sold for the year

was $1,378,000.

Required

Find the following by completing a cost of goods sold statement.

a. Cost of direct materials purchased during the year.

b. Cost of goods manufactured during the year.

c. Total manufacturing costs incurred during the year.

Lan69479_ch02_042-091.indd 73 31/10/18 10:55 AM

74 Part I Introduction and Overview

(LO 2-2)

2-38. Prepare Statements for a Service Company

Chuck’s Brokerage Service (CBS) is a discount financial services firm offering clients investment

advice, trading services, and a variety of mutual funds for investment. Chuck has collected the fol-

lowing information for October.

A B C



Advertising and marketing $ ,

 Brokerage commissions (revenues) ,,

 Building rent and utilities

,



Fees from clients for investment advice

,,

 Labor cost for advice ,,

 Managers’ salaries ,

 Sales commissions to brokers ,

 Training programs for brokers ,,

 Fees paid to execute trades ,,



Required

Prepare an income statement for October for CBS.

(LO 2-2)

2-39. Prepare Statements for a Service Company

Where2 Services is a small service firm that advises high school students on college opportunities.

Joseph Kapp, the founder and president, has collected the following information for March.

A B C

Advertising costs $ ,

2 Building rent and utilities ,

3 Printing, fax, and computing costs

,

Sales

,

5 Training costs 

6 Travel expenses ,

7 Wages for part-time employees ,

Required

Prepare an income statement for March for Where2 Services.

(LO 2-2)

2-40. Prepare Statements for a Service Company

The following data are available for Remington Advisors for the month just ended.

Gross margin ........................................... $ ,

Operating proﬁt ....................................... ,

Revenues.................................................. ,,

Required

Find the following by completing a cost of goods sold statement.

a. Marketing and administrative costs.

b. Cost of services sold.

(LO 2-2))

2-41. Prepare Statements for a Service Company

Lead! Inc. offers executive coaching services to small business owners. Lead!’s operating profits

average 20 percent of revenues and its marketing and administrative costs average 25 percent of the

cost of services sold.

Required

Lead! Inc. expects revenues to be $600,000 for April. Prepare an income statement for April for

Lead! Inc. assuming its expectations are met.

Lan69479_ch02_042-091.indd 74 31/10/18 10:55 AM

Chapter 2 Cost Concepts and Behavior 75

2-42. Prepare Statements for a Manufacturing Company (LO 2-2, 4)

The following balances are from the accounts of Crabtree Machining Company.

January  (Beginning) December  (Ending)

Direct materials inventory ................... $, $,

Work-in-process inventory .................. , ,

Finished goods inventory .................... , ,

Direct materials purchased during the year amount to $717,600, and the cost of goods sold for the

year was $2,606,880.

Required

Reconstruct a cost of goods sold statement and fill in the following missing data.

a. Cost of direct materials used during the year.

b. Cost of goods manufactured during the year.

c. Total manufacturing costs incurred during the year.

2-43. Basic Concepts (LO 2-1, 2)

The following data refer to one year for Monroe Fabricators. Fill in the blanks.

Direct materials inventory, January ....................

$ ,

Direct materials inventory, December  ................

Work-in-process inventory, January  ................... ,

ork-in-process inventory, December ................ ,

Finished goods inventory, January  .................... ,

Finished goods inventory, December  ................ 

Purchases of direct materials .......................... ,

Cost of goods manufactured during the year............. ,

Total manufacturing costs ............................. b.

Cost of goods sold ...................................

,

Gross margin ........................................

,

Direct labor ..........................................

Direct materials used .................................

,

Manufacturing overhead ..............................

,

Sales revenue........................................

2-44. Basic Concepts (LO 2-1, 2)

The following data refers to one month for Talmidge Company. Fill in the blanks.

A B C



Direct materials inventory, March 1

$ ,



Direct materials inventory, March 31

,

 Work-in-process inventory, March 1

,



Work-in-process inventory, March 31

a. ________

 Finished goods inventory, March 1

,

 Finished goods inventory, March 31

,

 Purchases of direct materials

b. ________



Cost of goods manufactured during the month ,



Total manufacturing costs ,



Cost of goods sold

c. ________



Gross margin ,



Direct labor ,



Direct materials used ,



Manufacturing overhead

d. ________



Sales revenue ,



Lan69479_ch02_042-091.indd 75 31/10/18 10:55 AM

76 Part I Introduction and Overview

(LO 2-2)

2-45. Prepare Statements for a Merchandising Company

The cost accountant for Angie’s Apparel has compiled the following information for last month’s

operations.

Administrative costs ...................................

$ 42,000

Merchandise inventory, July ...........................

9,000

Merchandise inventory, July  .........................

7,500

Merchandise purchases ................................

360,000

Sales commissions ....................................

27,000

Sales revenue.........................................

570,000

Store rent ............................................

9,000

Store utilities..........................................

16,500

Transportation-in costs .................................

27,000

Required

Prepare an income statement with a supporting cost of goods sold statement.

(LO 2-2)

2-46. Prepare Statements for a Merchandising Company

University Electronics has provided the following information for last year.

Sales revenue.........................................

$4,000,000

Store rent ............................................

220,000

Store utilities..........................................

135,000

Administrative costs ...................................

290,000

Sales commissions ....................................

650,000

Merchandise purchases ................................

2,750,000

Transportation-in costs .................................

105,000

Merchandise inventory, March .........................

185,000

Merchandise inventory, February  .....................

210,000

Required

Prepare an income statement for last year with a supporting cost of goods sold statement.

(LO 2-5)

2-47. Cost Behavior and Forecasting

Dayton, Inc., manufactured 30,000 units of product last month and identified the following costs

associated with the manufacturing activity.

Variable costs:

Direct materials used .........................................

$ 510,000

Direct labor..................................................

1,120,000

Indirect materials and supplies.................................

120,000

Power to run plant equipment .................................

140,000

Fixed costs:

Supervisory salaries ..........................................

470,000

Plant utilities (other than power to run plant equipment) ...........

120,000

Depreciation on plant and equipment (straight-line, time basis) ....

67,500

Property taxes on building.....................................

98,500

Required

Unit variable costs and total fixed costs are expected to remain unchanged next month. Calculate

the unit cost and the total cost if 36,000 units are produced next month.

(LO 2-5)

2-48. Cost Behavior and Forecasting

Sophia’s Restaurant served 5,000 meals last quarter. Sophia recorded the following costs with

those meals.

Lan69479_ch02_042-091.indd 76 31/10/18 10:55 AM

Chapter 2 Cost Concepts and Behavior 77

Variable costs:

Ingredients used .............................................

$,

Direct labor..................................................

,

Indirect materials and supplies.................................

,

Utilities .....................................................

,

Fixed costs:

Managers’ salaries ...........................................

,

Rent ........................................................

,

Depreciation on equipment (straight-line, time basis) .............

,

Other ﬁxed costs .............................................

,

Required

Unit variable costs and total fixed costs are expected to remain unchanged next quarter. Calculate

the unit cost and the total cost if 4,500 meals are served next quarter.

2-49. Cost Behavior and Forecasting (LO 2-5)

Refer to the data in Exercise 2-48.

Variable costs:

Ingredients used .............................................

$,

Direct labor..................................................

,

Indirect materials and supplies.................................

,

Utilities .....................................................

,

Fixed costs:

Managers’ salaries ...........................................

,

Rent ........................................................

,

Depreciation on equipment (straight-line, time basis) .............

,

Other ﬁxed costs .............................................

,

Required

Suppose that Sophia expects to serve 15 percent more meals in the next quarter. Unit variable costs

are expected to remain unchanged. However, Sophia knows that if the restaurant serves over 5,500

meals in a quarter, she must hire an additional manager (part-time) at a cost of $6,450 for the quar-

ter. Other fixed costs are expected to increase by 10 percent.

Calculate the unit cost and the total cost if 5,750 meals are served next quarter.

2-50. Components of Full Costs

(LO 2-6)

Madrid Corporation has compiled the following information from the accounting system for the

one pr

oduct it sells.

Sales price ......................................... $ per unit

Fixed costs (for the month)

Marketing and administrative ....................... $,

Manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . $,

Variable costs (per unit)

Marketing and administrative ....................... $

Direct materials ................................... $

Manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . $

Direct labor....................................... $

Units produced and sold (for the month) ............... ,

Required

Determine each of the following unit costs:

a. Variable manufacturing cost.

b. Variable cost.

c. Full absorption cost.

d. Full cost.

Lan69479_ch02_042-091.indd 77 31/10/18 10:55 AM

78 Part I Introduction and Overview

(LO 2-6)

2-51. Components of Full Costs

Refer to Exercise 2-50.

Required

Compute:

a. Product costs per unit.

b. Period costs for the period.

(LO 2-6)

2-52. Components of Full Costs

Larcker Manufacturing’s cost accountant has provided you with the following information for

January operations.

Direct materials ..................................... $ per unit

Fixed manufacturing overhead costs .................. $,

Sales price ......................................... $ per unit

Variable manufacturing overhead ..................... $ per unit

Direct labor......................................... $ per unit

Fixed marketing and administrative costs .............. $,

Units produced and sold ............................. ,

Variable marketing and administrative costs ............ $ per unit

Required

Determine each of the following unit costs:

a. Variable cost.

b. Variable manufacturing cost.

c. Full absorption cost.

d. Full cost.

e. Profit margin.

f. Gross margin.

g. Contribution margin.

(LO 2-7)

2-53. Gross Margin and Contribution Margin Income Statements

Refer to Exercise 2-52.

Required

Prepare:

a. A gross margin income statement.

b. A contribution margin income statement.

(LO 2-7)

2-54. Gross Margin and Contribution Margin Income Statements

The following data are from the accounting records of Niles Castings for year 2.

Units produced and sold ................................ ,

Total revenues and costs

Sales revenue ....................................... $,

Direct materials costs................................. ,

Direct labor costs .................................... ,

Variable manufacturing overhead ...................... ,

Fixed manufacturing overhead......................... ,

Variable marketing and administrative costs ............. ,

Fixed marketing and administrative costs ............... ,

Required

Prepare:

a. A gross margin income statement.

b. A contribution margin income statement.

Lan69479_ch02_042-091.indd 78 31/10/18 10:55 AM

79 Chapter 2 Cost Concepts and Behavior

2-55. Gross Margin and Contribution Margin Income Statements (LO 2-7)

Alpine Coffee Roasters reports the following information for November.

Units produced and sold .................................. ,

Per unit revenue and costs:

Sales revenue ......................................... $.

Direct materials costs................................... .

Direct labor costs ...................................... .

Variable manufacturing overhead ........................ .

Fixed manufacturing overhead based on a volume

of , units ...................................... .

Variable marketing and administrative costs ............... .

Fixed marketing and administrative costs

based on a volume of , units

..................... .

Required

Prepare:

a. A gross margin income statement.

b. A contribution margin income statement.

2-56. Value Income Statement

(LO 2-7)

Ralph’s Restaurant has the following information for year 2, when several new employees were

added to the waitstaff.

Sales revenue ......................................... $,,

Cost of food served

.................................... ,

Employee wages and salaries

........................... ,

Manager salaries

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ,

Building costs (rent, utilities, etc.)

........................ ,

5 percent of this cost was for food that was not used by the expiration date, and 10 percent

was for food that was incorrectly prepared because of errors in orders taken.

15 percent of this cost was for time spent by cooks to reprepare orders that were incor-

rectly prepared because of errors in orders taken.

20 percent of this cost was time taken to address customer complaints about incorrect orders.

80 percent of the building was used.

Required

a. Using the traditional income statement format, prepare a value income statement.

b. What value would there be to Ralph from preparing the same information in year 3?

2-57. Value Income Statement (LO 2-7)

DeLuxe Limo Service has the following information for March.

A B C





Sales revenue

$ ,



Variable costs of operations, excluding labor costs

,



Employee wages and salaries

,



Manager salaries

,

 Fixed cost of automobiles

,

Building costs (rent, utilities, etc.)

,





 percent of this cost was wasted due to poor directions given to limo drivers.



 percent of this cost was for time spent by limo drivers because of poor directions.



 percent of this cost was time taken to address customer complaints.



The limos have  percent unused capacity.



The building has  percent unused capacity.



Lan69479_ch02_042-091.indd 79 31/10/18 10:55 AM

80 Part I Introduction and Overview



Required

a. Using the traditional income statement format, prepare a value income statement.

b. What value would there be to the managers at DeLuxe from preparing the same information

in April?

PROBLEMS All applicable Problems are included in Connect.

(LO 2-2, 6)

2-58. Cost Concepts

The following information comes from the accounting records for Chelsea, Inc., for May.

Direct materials inventory, May  .......................... $ ,

Direct materials inventory, May ......................... ,

Work-in-process inventory, May  ......................... ,

Work-in-process inventory, May  . . . . . . . . . . . . . . . . . . . . . . . . ,

Finished goods inventory, May  .......................... ,

Finished goods inventory, May  ......................... ,

Direct materials purchased during May .................... ,

Direct labor costs,May................................... ,

Manufacturing overhead, May ............................ ,

Required

Compute for the month of May:

a. Total prime costs.

b. Total conversion costs.

c. Total manufacturing costs.

d. Cost of goods manufactured.

e. Cost of goods sold.

(LO 2-2, 6)

2-59. Cost Concepts

The controller at Lawrence Components asks for your help in sorting out some cost information.

She is called to a meeting but hands you the following information for April.

Prime costs, April....................................... $ ,

Total manufacturing costs, April . . . . . . . . . . . . . . . . . . . . . . . . . . ,

Cost of goods manufactured, April ....................... ,

Cost of goods sold, April ................................ ,

Direct materials inventory, April  ....................... ,

Work-in-process inventory, April  ........................ ,

Finished goods inventory, April  ....................... ,

Direct materials purchased, April ......................... ,

Direct labor costs, April ................................. ,

Required

Compute:

a. Direct materials used, April.

b. Direct materials inventory, April 1.

c. Conversion costs, April.

d. Work-in-process inventory, April 30.

e. Manufacturing overhead, April.

f. Finished goods inventory, April 1.

Lan69479_ch02_042-091.indd 80 31/10/18 10:55 AM

Chapter 2 Cost Concepts and Behavior 81

2-60. Cost Concepts (LO 2-2, 6)

Columbia Products produced and sold 900 units of the company’s only product in March. You have

collected the following information from the accounting records.

Sales price (per unit)............................... $ 

Manufacturing costs:

Fixed overhead (for the month) ................... ,

Direct labor (per unit) ............................ 

Direct materials (per unit)......................... 

Variable overhead (per unit) ...................... 

Marketing and administrative costs:

Fixed costs (for the month) ....................... ,

Variable costs (per unit) .......................... 

Required

a. Compute:

Variable manufacturing cost per unit.

Full cost per unit.

Variable cost per unit.

Full absorption cost per unit.

Prime cost per unit.

Conversion cost per unit.

Profit margin per unit.

Contribution margin per unit.

Gross margin per unit.

b. If the number of units produced increases from 900 to 1,200, which is within the relevant

range, cost per unit will decrease (you can check this by redoing requirement [a] above).

Therefore, we should recommend that Columbia Products increase its production to reduce its

costs. Do you agree? Explain.

2-61. Prepare Statements for a Manufacturing Company

(LO 2-2, 4)

Yolo Windows, a manufacturer of windows for commercial buildings, reports the following

account information for last year (all costs are in thousands of dollars).

Information on January  (Beginning):

Direct materials inventory ..........................$ 

Work-in-process inventory.......................... 

Finished goods inventory .......................... 

Information for the year:

Administrative costs ............................ $ ,

Direct labor.................................... ,

Direct materials purchases ...................... ,

Factory and machine depreciation ............... ,

Factory supervision ............................ 

Factory utilities ................................ 

Indirect factory labor ........................... ,

Indirect materials and supplies................... 

Marketing costs................................ 

Property taxes on factory........................ 

Sales revenue ................................. ,

Information on December  (Ending):

Direct materials inventory ..........................$ 

Work-in-process inventory.......................... 

Finished goods inventory .......................... 

Required

Prepare an income statement with a supporting cost of goods sold statement.

Lan69479_ch02_042-091.indd 81 31/10/18 10:55 AM

82 Part I Introduction and Overview

(LO 2-2, 4)

2-62. Prepare Statements for a Manufacturing Company

Mesa Designs produces a variety of hardware products, primarily for the do-it-yourself (DIY)

market. As part of your job interview as a summer intern at Mesa, the cost accountant provides you

with the following (fictitious) data for the year (in $000).

A B C D



Inventory information:



// //

 Direct materials

$  $ 



Work-in-process  

 Finished goods , ,



 Other information:

For the year ’



Administrative costs

$ ,



Depreciation (Factory)

,



Depreciation (Machines)

,



Direct labor

,



Direct materials purchased

,



Indirect labor (Factory) ,



Indirect materials (Factory) 



Property taxes (Factory)





Selling costs

,



Sales revenue ,



Utilities (Factory) ,



Required

Prepare the income statement with a supporting cost of goods sold statement.

(LO 2-2, 4)

2-63. Prepare Statements for a Manufacturing Company

The administrative offices and manufacturing plant of Billings Tool & Die share the same build-

ing. The following information (in $000s) appears in the accounting records for last year.

Administrative costs ...................................... $ 9,600

Building and machine depreciation

(75% of this amount is for factory) ........................ 5,400

Building utilities (90% of this amount is for factory)............ 7,500

Direct labor.............................................. 5,040

Direct materials inventory, December 31 .................... 84

Direct materials inventory, January 1 ....................... 72

Direct materials purchases ................................ 21,900

Factory supervision....................................... 2,940

Finished goods inventory, December 31 .................... 390

Finished goods inventory, January 1........................ 324

Indirect factory labor...................................... 5,472

Indirect materials and supplies............................. 4,110

Marketing costs .......................................... 5,226

Property taxes on building

(80% of this amount is for factory) ........................ 5,040

Sales revenue ........................................... 77,820

Work-in-process inventory, December 31 ................... 174

Work-in-process inventory, January 1 ....................... 192

Required

Prepare an income statement with a supporting cost of goods sold statement.

(LO 2-3)

2-64. Cost Allocation with Cost Flow Diagram

Coastal Computer operates two retail outlets in Oakview, one on Main Street and the other in Lakeland

Mall. The stores share the use of a central accounting department. The cost of the accounting depart-

ment for last year was $180,000. The following are the operating results for the two stores for the year.

Lan69479_ch02_042-091.indd 82 31/10/18 10:55 AM

Chapter 2 Cost Concepts and Behavior 83

Main Street Lakeland Mall

Sales revenue ......................... $,, $,,

Number of computers sold .............. , ,

Required

a. Allocate the cost of the central accounting department to the two stores based on:

Number of computers sold.

Store revenue.

b. Draw a cost flow diagram to illustrate your answer to requirement (a), part (2).

2-65. Cost Allocation with Cost Flow Diagram (LO 2-3)

Wayne Casting, Inc., produces a product made from a metal alloy. Wayne buys the alloy from two

different suppliers, Chillicothe Metals and Ames Supply, in approximately equal amounts because

of supply constraints at both vendors. The material from Chillicothe is less expensive to buy but

more difficult to use, resulting in greater waste. The metal alloy is highly toxic and any waste

requires costly handling to avoid environmental accidents. Last year the cost of handling the waste

totaled $300,000. Additional data from last year’s operations are shown as follows.

Chillicothe

Metals

Ames

Supply

Amount of material purchased (tons)......  

Amount of waste (tons) ................. . .

Cost of purchases ...................... $, $,

Required

a. Allocate the cost of the waste handling to the two suppliers based on:

Amount of material purchased.

Amount of waste.

Cost of material purchased.

b. Draw a cost flow diagram to illustrate your answer to requirement (a), part (1).

2-66. Cost Allocation with Cost Flow Diagram (LO 2-3)

The library at Pacific Business School (PBS) serves both undergraduate and graduate programs. The

dean of PBS is interested in evaluating the profitability of the degree programs and has asked the head

of the library, Rex Gilmore, to allocate the annual library cost of $4,035,000 to the two programs.

Rex believes that two cost drivers explain most of the costs—number of students and credit

hours. Using information from a previous analysis, he split the annual library budget as follows.

A B

C D



Costs driven by number of students



Library management $ ,

 Acquisitions

,,



$ ,,



 Costs driven by number of credit hours

 Computer support

$ ,



Building maintenance

,



Library sta

,



Utilities and supplies

,



$ ,,



Total library costs

$ ,,







Data on students and credit hours

Undergraduate

Graduate



Number of students

 



Number of credit hours , ,



Lan69479_ch02_042-091.indd 83 31/10/18 10:55 AM

84 Part I Introduction and Overview



Required

a. Allocate the cost of the library to the two programs (undergraduate and graduate).

b. Draw a cost flow diagram to illustrate your answer to requirement (a).

(LO 2-3)

2-67. Cost Allocation and Pricing

Greenfield Consultants conducts analyses of public policy issues. The company has two units: Govern-

ment (with various U.S. government agencies as the only clients) and Corporate (with several corpora-

tions as clients). Government business is charged based on the total costs (direct and indirect) plus a

15 percent fee (profit). Corporate clients are charged a fixed fee negotiated at the beginning of the project.

During the planning process for the following year, the controller has estimated costs for the

two units.

Corporate Government Total

Direct costs .......................... $, ,, $,,

Direct contract hours worked ........... , , ,

The controller expects indirect costs to total $4.5 million next year. Revenues from Corporate

clients are expected to be $1.2 million.

Required

a. Suppose Greenfield chooses to allocate indirect cost based on direct cost.

What cost would be allocated to the two units (Corporate and Government)?

What total revenue would they expect to collect next year?

b. Suppose Greenfield chooses to allocate indirect cost based on direct contract hours worked.

What cost would be allocated to the two units (Corporate and Government)?

What total revenue would they expect to collect next year?

(LO 2-3)

2-68. Cost Allocation and Pricing

Consider the Business Application, “Indirect Costs and Allocating Costs to Contracts.”

Required

a. How should Greenfield Consultants allocate indirect costs to units? Why?

b. What ethical issues arise for the controller at Greenfield related to cost allocation?

(LO 2-1, 6)

2-69. Find the Unknown Information

After a computer failure, you are trying to reconstruct some financial results for the year that just

ended. While you know that backups are available, it will take too long to get the information you

want. You have been able to collect the following information.

Direct materials inventory, January  (Beginning) ............ $,

Direct materials inventory, December  (Ending) ........... ,

Work-in-process inventory, January  (Beginning) ........... ,

Work-in-process inventory, December  (Ending)........... ,

Finished goods inventory, December  (Ending) ........... ,

Manufacturing overhead ................................. ,

Cost of goods manufactured during this year ............... ,

Total manufacturing costs ................................ ,

Cost of goods sold ...................................... ,

Direct labor............................................. ,

Average sales price per unit .............................. 

Gross margin percentage ................................ .%

Required

Find the following:

a. Finished goods inventory, January 1.

b. Direct materials used for the year.

c. Sales revenue.

Lan69479_ch02_042-091.indd 84 31/10/18 10:55 AM

85 Chapter 2 Cost Concepts and Behavior

2-70. Find the Unknown Information

(LO 2-1, 6)

Just before class starts, you realize that you have mistakenly recycled the second page of your cost

accounting homework assignment. Fortunately, you still have the first page of the printout from

your spreadsheet (shown as follows) and you remember that you were able to determine the items

on the recycled page from this information.

A B C



Direct materials inventory, January  $ ,

 Direct materials inventory, December  ,

 Work-in-process inventory, January 

,



Work-in-process inventory, December 

,

 Finished goods inventory, January  ,

 Finished goods inventory, December 

,

 Cost of goods manufactured during this year

,

 Total manufacturing costs

,

 Direct labor

,



Manufacturing overhead

,

 Average selling price per unit



 Gross margin percentage (as a percentage of sales)

%



Required

Find the following:

a. Cost of goods sold.

b. Direct materials used.

c. Purchases of direct materials.

d. Sales revenue.

2-71. Cost Allocation and Regulated Prices (LO 2-3)

The City of Imperial Falls contracts with Evergreen Waste Collection to provide solid waste collec-

tion to households and businesses. Until recently, Evergreen had an exclusive franchise to provide

this service in Imperial Falls, which meant that other waste collection firms could not operate

legally in the city. The price per pound of waste collected was regulated at 20 percent above the

average total cost of collection.

Cost data for the most recent year of operations for Evergreen are as follows.

Administrative cost ............................ $ ,

Operating costs—trucks........................ ,,

Other collection costs ......................... ,

Data on customers for the most recent year are as follows.

Households Businesses

Number of customers................... , ,

Waste collected (tons) .................. , ,

The City Council of Imperial Falls is considering allowing other private waste haulers to

collect waste from businesses but not from households. Service to businesses from other waste col-

lection firms would not be subject to price regulation. Based on information from neighboring

cities, the price that other private waste collection firms will charge is estimated to be $0.04 per

pound (= $80 per ton).

Evergreen’s CEO has approached the city council with a proposal to change the way costs are

allocated to households and businesses, which will result in different rates for households and busi-

nesses. She proposes that administrative costs and truck operating costs be allocated based on the

number of customers and the other collection costs be allocated based on pounds collected. The

Lan69479_ch02_042-091.indd 85 31/10/18 10:55 AM

86 Part I Introduction and Overview

total costs allocated to households would then be divided by the estimated number of pounds col-

lected from households to determine the cost of collection. The rate would then be 20 percent

above the cost. The rate for businesses would be determined using the same calculation.

Required

a. Based on cost data from the most recent year, what is the price per pound charged by Evergreen

for waste collection under the current system (the same rate for both types of customers)?

b. Based on cost and waste data from the most recent year, what would be the price per pound

charged to households and to businesses by Evergreen for waste collection if the CEO’s pro-

posal were accepted?

c. As a staff member to one of the council members, would you support the proposal to change

the way costs are allocated? Explain.

(LO 2-1, 2, 6)

2-72. Reconstruct Financial Statements

Koufax Materials Corporation produces plastic products for home appliances and electronics. The

financial department has produced the following information for the year ended December 31.

A B

 Administrative salaries $ ,,

 Depreciation on the administrative building ,,

 Depreciation on the manufacturing plant ,,

 Direct labor ,,

 Direct materials inventory, January  ,,

 Direct materials inventory, December  ,,

 Direct materials purchased during the year ,,

 Distribution costs ,

 Finished goods inventory, January  ,,

 Finished goods inventory, December  ,,



Indirect labor ,

 Insurance (on manufacturing plant

)

,

 Legal fees ,

 Maintenance (on the manufacturing plant) ,

 Manufacturing plant utilities ,

 Marketing cost

,

 Other manufacturing plant costs ,

 Sales revenue ,,

 Taxes (on manufacturing plant and property) ,

 Work

-in-process inventory

, January  ,

 W

ork

-in-process inventory, December  ,







Required

Prepare a cost of goods manufactured and sold statement and an income statement.

(LO 2-1, 6)

2-73. Reconstruct Financial Statements

San Ysidro Company manufactures hiking equipment. The company’s administrative and manu-

facturing operations share the company’s only building. Eighty percent of the building is used for

manufacturing, and the remainder is used for administrative activities. Indirect labor is 8 percent of

direct labor.

The cost accountant at San Ysidro has compiled the following information for the year ended

December 31.

Lan69479_ch02_042-091.indd 86 16/11/18 1:12 PM

Chapter 2 Cost Concepts and Behavior 87

A B C



Administrative salaries

$ ,



Attorney fees to settle zoning dispute

,



Building depreciation (manufacturing portion only)

,



Cost of goods manufactured

,,

 Direct materials inventory, December  ,

 Direct materials purchased during the year ,,

 Direct materials used ,,



Distribution costs ,



Finished goods inventory, January  ,



Finished goods inventory, December  ,



Insurance (on plant machinery) ,



Maintenance (on plant machinery) ,



Marketing costs ,



Other plant costs ,



Plant utilities ,



Sales revenue ,,



Taxes on manufacturing property ,



Total (direct and indirect) labor ,,



Work-in-process inventory, January  ,



Work-in-process inventory, December  ,



Required

Prepare a cost of goods manufactured and sold statement and an income statement.

2-74. Reconstruct Financial Statements (LO 2-1, 6)

Westlake, Inc., produces metal fittings for the aerospace industry. The administrative and manu-

facturing operations occupy the same 200,000-square-foot building. The manufacturing plant

uses 150,000 square feet. Depreciation is assigned based on building use. Indirect labor represents

15 percent of the total manufacturing plant labor.

The financial information for the year just ended is shown as follows.

A B

(Thousands of Dollars)

3 Administrative costs $ 160

4 Total building depreciation 400

5 Direct materials inventory, January 1

6 Direct materials inventory, December 31 20

7 Direct materials purchased during the year 1,570

8 Finished goods inventory, December 31 80

9 Indirect labor 180

10 Maintenance on plant machinery 140

11 Marketing costs 120

12 Operating proﬁt 960

13 Other plant overhead 83

14 Plant supervision and administration 155

15 Plant supplies and indirect materials 67

16 Sales revenue 5,000

17 Ta xes on manufacturing property 117

18 Work

-in-process inventory, January 1

19 Work-in-process inventory, December 31 110

Required

Prepare a cost of goods manufactured and sold statement and an income statement.

Lan69479_ch02_042-091.indd 87 16/11/18 1:13 PM

88 Part I Introduction and Overview

(LO 2-2)

2-75. Finding Unknowns

Mary’s Mugs produces and sells various types of ceramic mugs. The business began operations on

January 1, year 1, and its costs incurred during the year include the following.

Variable costs (based on mugs produced):

Direct materials cost.................................... $ ,

Direct manufacturing labor costs ......................... ,

Indirect manufacturing costs............................. ,

Administration and marketing............................ ,

Fixed costs:

Administration and marketing costs ...................... ,

Indirect manufacturing costs............................. ,

On December 31, year 1, direct materials inventory consisted of 3,750 pounds of material.

Production in that year was 20,000 mugs. All prices and unit variable costs remained constant dur-

ing the year. Sales revenue for year 1 was $73,312. Finished goods inventory was $6,105 on

December 31, year 1. Each finished mug requires 0.4 pounds of material.

Required

Compute the following:

a. Direct materials inventory cost, December 31, year 1.

b. Finished goods ending inventory in units on December 31, year 1.

c. Selling price per unit.

d. Operating profit for year 1.

(LO 2-2)

2-76. Finding Unknowns

BS&T Partners has developed a new hubcap with the model name Spinnin’ Wheel. Production and

sales started August 3. As of August 2, there were no direct materials in inventory. Data for the

month of August include the following.

Direct labor cost per unit

.............................. $.

Direct labor-hours worked, August ...................... ________

Direct labor wage rate per direct labor-hour .............. $.

Direct materials cost per unit

........................... $.

Direct materials cost per pound of direct material ......... $.

Direct materials inventory (cost), August ............... $,

Direct materials inventory (pounds), August ............ ________

Finished goods inventory (cost), August  ............... $,

Finished goods inventory (units), August  .............. ________

Manufacturing overhead cost per unit

................... $.

Operating proﬁt, August ............................... $,

Production (units), August .............................. ________

Sales revenue, August ................................. $,

Sales (units), August ................................... ________

Sales price per unit .................................... ________

Selling, general, and administrative costs per unit

........ $.

Unit cost based on units produced in August.

Unit cost based on units sold in August.

Required

Complete the table.

Lan69479_ch02_042-091.indd 88 31/10/18 10:56 AM

Chapter 2 Cost Concepts and Behavior 89

INTEGRATIVE CASE

2-77. Analyze the Impact of a Decision on Income Statements (LO 2-2)

You were appointed the manager of Drive Systems Division (DSD) at Tunes2Go, a manufacturer

of portable music devices using the latest developments in hard drive technology, on December 15

last year. DSD manufactures the drive assembly, M-24, for the company’s most popular product.

Your bonus is determined as a percentage of your division’s operating profits before taxes.

One of your first major investment decisions was to invest $3 million in automated testing

equipment for the M-24. The equipment was installed and in operation on January 1 of this year.

This morning, J. Bradley Finch III, the assistant manager of the division (and, not coinciden-

tally, the grandson of the company founder and son of the current CEO) told you about an offer by

Pan-Pacific Electronics. Pan-Pacific wants to rent to DSD a new testing machine that could be

installed on December 31 (only two weeks from now) for an annual rental charge of $690,000. The

new equipment would enable you to increase your division’s annual revenue by 7 percent. This

new, more efficient machine would also decrease fixed cash expenditures by 6 percent.

Without the new machine, operating revenues and costs for the year are estimated to be as fol-

lows. Sales revenue and fixed and variable operating costs are all cash.

Sales revenue ................................ $,,

Variable operating costs........................ ,

Fixed operating costs .......................... ,,

Equipment depreciation ........................ ,

Other depreciation ............................ ,

If you rent the new testing equipment, DSD will have to write off the cost of the automated

testing equipment this year because it has no salvage value. Equipment depreciation shown in the

income statement is for this automated testing equipment. Equipment losses are included in the

bonus and operating profit computation.

Because the new machine will be installed on a company holiday, there will be no effect on

operations from the changeover. Ignore any possible tax effects. Assume that the data given in your

expected income statement are the actual amounts for this year and next year if the current equip-

ment is kept.

Required

a. Assume the new testing equipment is rented and installed on December 31. What will be the

impact on this year’s divisional operating profit?

b. Assume the new testing equipment is rented and installed on December 31. What will be the

impact on next year’s divisional operating profit?

c. Would you rent the new equipment? Why or why not?

SOLUTIONS TO SELFSTUDY QUESTIONS

PACIFIC PARTS

Income Statement

Sales revenue .................................................... $,,

Cost of goods sold (see following statement) ......................... ,,

Gross margin ..................................................... $,,

Less

Marketing costs................................................. ,,

Administrative costs ............................................. ,,

Operating proﬁt ................................................... $ ,

Lan69479_ch02_042-091.indd 89 31/10/18 10:56 AM

90 Part I Introduction and Overview

PACIFIC PARTS

Statement of Cost of Goods Manufactured and Sold

Beginning work-in-process inventory, January  $ ,

Manufacturing costs during the year

Direct materials

Beginning inventory, January  ......... $ ,

Add purchases ....................... ,,

.............. Direct materials available $ ,,

Less ending inventory, December  .... ,

Direct materials put into production ....... $,,

Direct labor............................. ,,

Manufacturing overhead

Supervisory and indirect labor .......... $ ,

Supplies and indirect materials ......... ,

Heat, light, and power—plant ........... ,

Plant maintenance and repairs.......... ,

Depreciation—manufacturing ........... ,

Miscellaneous manufacturing costs...... ,

Total manufacturing overhead .......... $,,

Total manufacturing costs incurred during the year ................... $,,

Total cost of work-in-process during the year .......................... $,,

Less ending work-in-process inventory, December  .................. ,

Cost of goods manufactured during the year .......................... $,,

Beginning ﬁnished goods inventory, January ......................... ,

Finished goods inventory available for sale............................ $,,

Less ending ﬁnished goods inventory, December  ................... ,

Cost of goods manufactured and sold ................................ $,,

Lan69479_ch02_042-091.indd 90 31/10/18 10:56 AM

Labor

$2,436,000

Direct

labor

$1,928,000

Product

cost

$4,932,000

Indirect

labor

$508,000

Manufacturing

overhead

$1,668,000

Materials

$1,392,000

Direct

materials

$1,336,000

Prime

costs

$3,264,000

(

$1,336,000

$1,928,000)

Conversion

costs

$3,596,000

(

$1,928,000

$1,668,000)

Indirect

materials

$56,000

Manufacturing

utilities, rent, etc.

$1,104,000

Chapter 2 Cost Concepts and Behavior 91

3. Fixed manufacturing = $7.50 (= $12,000 ÷ 1,600)

Fixed marketing and administration = $8.75 (= $14,000 ÷ 1,600)

4. Gross margin = Sales price − Full absorption cost = Sales price − (Variable manufacturing

+ Fixed manufacturing) = $45 − ($23 + $6) = $16

Contribution margin = Sales price − Variable costs

= Sales price − (Variable manufacturing + Variable marketing and administrative)

= $45 − ($23 + $3) = $19

Operating profit = Sales price − Full cost to make and sell product

= Sales price − (Variable manufacturing + Fixed manufacturing + Variable marketing and

administrative + Fixed marketing and administrative)

= $45 − ($23 + $6 + $3 + $7)

= $6

(Note: The gross margin does not change from Exhibit 2.12 because marketing and adminis-

trative costs are subtracted after gross margin.)

5. Gross margin = $45 − ($23 + $5) = $17

Contribution margin = $45 − ($23 + $4) = $18

Operating profit = $45 − ($23 + $5 + $4 + $7) = $6

(Note: The contribution margin does not change from Exhibit 2.13; however, the gross margin

changes from Exhibit 2.12.)

Lan69479_ch02_042-091.indd 91 31/10/18 10:56 AM