Chapter Three

Basic Cost Management Concepts

 Learning Objectives

1 2 3 4
Recognize the strategic role Explain the cost driver Explain the cost concepts Demonstrate how costs
of basic cost management concepts at the activity, used in product and service flow through the accounts
concepts. volume, structural, and costing. and prepare and interpret
executional levels. an income statement for
both a manufacturing and a
merchandising company.

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 Strategic role of basic cost management
concepts
• Product and process complexity increase
overall costs.
• P&G put emphasis on cost reduction
through product and process simplification.
• In the early 1990s, P&G had as many a 50
different varieties of some of its brands
including different size containers and
flavors.
• Over a period of five years, P&G reduced its
product variety by one-half, and its profit
surged.
 Basic Definitions
• A cost is incurred when a resource is used for some purpose

• Costs are assembled into meaningful groups called cost pools (e.g.,
by type of cost or source)

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 More Basic Definitions
• Any factor that has the effect of changing the level of total cost is
called a cost driver

• A cost object is any product, service, customer, activity, or

organizational unit to which costs are assigned for some
management purpose

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 Cost Assignment

Cost assignment is the process of assigning costs to cost pools

or from cost pools to cost objects
– Direct costs can be conveniently and economically traced to a cost pool
or a cost object
– Indirect costs cannot be traced conveniently or economically to a cost
pool or a cost object
– Cost allocation is the assignment of indirect costs to cost pools and
cost objects through the use of cost drivers
– These cost drivers are often called allocation bases

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 Cost Assignment: General Principles

Resource Costs Cost Pools

Cost Objects
Electric Motor

Materials
Handling Assembly Dishwasher

Supervision

Packing
Materials Washing
Packing
Machine
Final
Inspection

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 Direct and Indirect Product:
Costs for a Manufacturer (1 of 3)
• Direct material costs = cost of materials that can be readily traced
to outputs = purchase price of materials + freight – purchase
discounts + reasonable allowance for scrap and defective units
• Indirect material costs = cost of materials that cannot be readily or
economically traced to outputs (e.g., rags, lubricants, and small
tools)

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 Direct and Indirect Product Costs:
Costs for a Manufacturer (2 of 3)
• Direct labor costs = labor that can be readily traced to outputs =
wages paid plus a reasonable allowance for nonproductive time (e.g.,
coffee breaks or personal time)
• Indirect labor costs = labor costs that cannot be readily or
economically traced to outputs (i.e., they are manufacturing support
costs). Examples include supervision, quality control, and
inspection

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 Direct and Indirect Product Costs:
Costs for a Manufacturer (3 of 3)
• Indirect costs for the manufacturer, including indirect materials,
indirect labor, and other indirect items are often combined in a cost pool
referred to as overhead (or factory overhead, or indirect manufacturing
costs)

• The three main types of costs, direct materials, direct labor, and
overhead, are sometimes condensed even further:
Direct materials + Direct labor = Prime costs
Direct labor + Overhead = Conversion costs

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 Cost Drivers

• Cost drivers provide two roles for the management accountant

– Assigning costs to cost objects
– Explaining cost behavior, i.e., how total cost changes as the cost driver
changes
• Four types of cost drivers:
– Activity-based
– Volume-based
– Structural
– Executional

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 Cost Drivers (continued)

• Activity-based cost (ABC) drivers are developed at a detailed level

of operations using activity analysis–a cost driver is determined for
each activity
• Volume-based cost drivers are developed at an aggregate level and
relate to the amount produced or quantity of service provided:
– The relationship between the cost driver and total cost is
approximately linear within a relatively short range of output

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 Volume-Based Cost Drivers:
Classification by Behavior
• Variable cost is the change in total cost associated with each
change in quantity of a selected cost driver
• Fixed cost is the portion of total cost that does not change
with changes in quantity of the selected cost driver
• Mixed cost is used to refer to a total cost figure that includes
both a fixed and variable component
• Step cost varies with the change in cost driver volume but
does so in steps

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Linear Approximation and Relevant Range

Total
Cost

3,500 3,600
Units of the Cost Driver
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 Fixed Costs – Exhibit 3.8

Total
Cost

$6,600
Total Fixed Cost
$6,500

$3,000

3,500 3,600
Units of the Cost Driver
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 Total Costs – Exhibit 3.8

Total
Total Cost
Cost
$6,600
$6,500
Total Variable Cost
$3,000
Total Fixed Cost

3,500 3,600
Units of the Cost Driver
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 Total Cost and Unit Cost

Fixed cost Variable cost

Total $100,000 $100,000 $80,000 $160,000
Units of
output 10,000 20,000 10,000 20,000
Per unit $10 $5 $8 $8
Total cost ÷ Units of output Total cost ÷ Units of output

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 Structural versus Executional Drivers

• Structural cost drivers facilitate strategic decision making because they

involve plans and decisions that have long-term effects
– Scale, experience, technology, and complexity are considered in hopes of
improving competitive position

• Executional cost drivers facilitate operational decision making by

focusing on short-term effects
– Workforce involvement, design of the production process, and supplier
relationships are examples of operational decisions

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 Product and Service Costing Concepts

• Product costs include only the costs necessary to complete the

product at the manufacturing step in the value chain
(manufacturing) or to purchase and transport the product to the
location of sale (merchandising)

• Period costs (also called non-product costs) include all other

costs incurred by the firm in managing or selling the product (costs
outside the manufacturing step of the value chain)

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Manufacturing versus
Merchandising
Exhibit 3.13
Note the movement of costs through the multiple
inventory accounts for a manufacturing firm
before arriving at Cost of Goods Sold.

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Inventory and Related Expense
Accounts
Exhibit 3.14
Both types of firms have a Cost of Good Sold
account. The difference is that the value for a
manufacturing firm is derived from the costs
incurred in the production process as opposed to
simply using the amount paid to a third party for
the completed inventory.

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 Qualitative Attributes of
Cost Information
– Accuracy (impacted by internal accounting controls)
– Timeliness (often involves sacrificing in the other two
areas)
– Cost and value of information (the cost of information is
affected by desired accuracy, timeliness, and level of
aggregation and should not outweigh the associated
benefits)

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 Chapter Summary (1 of 2)
• Cost assignment: the tracing of direct or allocation of indirect costs
to cost pools using cost drivers.

• Four types of cost behavior (and cost drivers):

– Activity-based;
– Volume-based;
• Variable cost
• Fixed cost
• Mixed cost
• Step cost
– Structural;
– Executional.

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 Chapter Summary (2 of 2)
• Product and service costing focuses on differentiating
product costs from period costs.

• Manufacturing and merchandising firms both have a Cost

of Goods Sold amount.

• Costs flow through three inventory accounts in a

manufacturing firm(materials inventory, work-in-process
inventory, and finished goods inventory); merchandising
firms have one inventory account (inventory held for sale).

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