Cost Concepts and Cost Allocation

Managerial Accounting
Chapter 2
Cost Concepts and

Cost Allocation
Managers’ Use of Cost Information
Managers use information about operating costs

to plan, perform, evaluate, and communicate
the results of operating activities.
Use the estimated costs to develop

budgets, estimate revenues, and
manage the organization’s work force.
PLAN:
Estimate operating costs
Estimate sales volume
Set prices
Prepare budgets
PERFORM:
Monitor profitability of products and services
Make decisions concerning products and services
Compute the unit cost of a product or service
EVALUATE:
Compute variances between estimated and actual
costs
Analyze variances, address causes, and revise future
plans
COMMUNICATE:
Prepare internal reports for management
Prepare external reports for stakeholders
Organizations use cost information to determine

profits and selling prices and to value inventories
Different types of organizations have different types

of costs:
Service organizations
Retail organizations
Manufacturing organizations
Cost Classifications and Their Uses
A single cost can be classified and used in several

ways, depending on the purpose of the analysis
Overview of Cost Classifications:

 Cost traceability
 Cost behavior
 Value-adding attributes
 Financial reporting
Cost Traceability: Control cost by determining which

are traceable to a particular cost object, such as a
service or product
Direct costs: costs that can be conveniently and

economically traced to a cost object
Indirect costs: costs that cannot be conveniently and

economically traced to a cost object.
Cost Behavior : Calculate the number of units that

must be sold to achieve a certain level of profit
Variable costs: costs that changes in direct

proportion to changes in the cost-driver level
Fixed costs: costs that remain unchanged regardless

of changes in the cost-driver
Value-adding Attributes: Identify the costs of

activities that do and do not add value to a product or
service
A value-adding cost: the cost of an activity that

increases the market value of a product or service.
A nonvalue-adding cost : the cost of an activity that

adds cost to a product or service but does not increase
its market value.
Financial Reporting: Classify costs for the

preparation of financial statements
Product costs: or inventoriable costs, are costs
assigned to inventory; they include direct materials,
direct labor, and overhead. Product costs appear on the
income statements as cost of goods sold and on the
balance sheet as inventory.
Period costs: or noninventoriable costs, are costs of
resources used during the accounting period that are
not assigned to products. They appear as operating
expensive on the income statement.
Financial Statements and the Reporting of Costs
The key to preparing an income statement or

a balance sheet in any kind of organization is
to determine its cost of goods or services sold
and the value of its inventories
1. Cost of Sales = Net Cost of Services Sold
2. Cost of Goods Sold = Beginning Merchandise

Inventory + Net Cost of Purchases – Ending
Merchandise Inventory
3. Cost of Goods Sold = Beginning Finished Goods

Inventory + Cost of Goods Manufactured – Ending
Finished Goods Inventory
4. Sales – Cost of Sales or Cost of Goods Sold = Gross

Margin – Operating Expenses = Operating Income
Statement of cost of goods manufactured as being

developed in three steps:
Step 1: Computed the cost of direct materials used
during the accounting period.
Step 2: Calculate total manufacturing costs for the
period.
Step 3: Determine total cost of goods manufactured
for the period.
Example: see page 63

Inventory Accounts in Manufacturing
Organizations
1.Purchase of Materials
2.Production of Goods
3.Product Completion
4.Product Sale
 See Table on page 66

The Manufacturing Cost Flow
Materials Inventory:
Materials Inventory, Ending Balance = Materials
Inventory, Beginning Balance + Cost of Materials
Purchased – Cost of Materials Used
Finished Goods Inventory:

Finished Goods Inventory, Ending Balance = Finished
Goods Inventory, Beginning Balance + Cost of Goods
Manufactured – Cost of Goods Sold
The Manufacturing Cost Flow
Work in Process Inventory:

Total Manufacturing Costs = Cost of Direct Materials
Used + Direct Labor Costs + Overhead Costs
Work in Process Inventory, Ending Balance = Work in

Process Inventory,Beginning Balance + Total
Manufacturing Costs – Cost of Goods Manufactured
Cost Allocation
Cost allocation methods comprise an important

part of a company’s cost management system.
Four types of cost objectives:

Service departments
Producing departments
Products/services, and
Customers.
Cost Allocation
Producing departments are where employees

Work on the organization’s products or services.
Service departments exist only to

support other departments or customers.
Cost Allocation
Direct costs can be physically traced to each department.
Indirect costs must be allocated.
Many companies develop allocation

methods to assign service department
costs to the producing departments.
Cost Allocation
All organizations accumulate costs for their

products or services for financial reporting purposes.
Increasingly, companies measure and manage

the costs and profitability of their customers.
Customer related costs include:

Order processing
Customer service sales commissions
Dedicated customer support
Cost Allocation
An accounting system will assign to a department’s output

all its direct costs plus all the indirect costs allocated to it.
A cost driver that has a logical, cause-effect relationship

to the cost will be used as a cost-allocation base
Cost Allocation Example
5-year lease
Computer Department
School of Business School of Engineering

Cost Allocation: Traditional Approach
1. Divide the costs in each

producing departments.
Direct costs Indirect costs
2. Assign direct costs to the appropriate

products, services, or customers.
Traditional Approach
3. Select one or more cost pools and related

cost drivers in each production department.
Indirect departmental costs
Cost Cost Cost

pool pool pool
Traditional Approach
4. Allocate costs
Costs
Product Product Product

A B C
Cost Allocation: Activity-Based Costing
Step 1:
Determine the key
components of the system.
Step 2:
Develop the relationships among
resources, activities, and cost objectives.
Activity-Based Costing
Step 3:
Collect relevant data concerning costs
and the physical flow of the cost-driver
units among resources and activities.
Step 4:
Calculate and interpret the new
activity-based cost information.
The End
End of Chapter 2

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Managerial Accounting

Cost Concepts and

Managers use information about operating costs

Use the estimated costs to develop

Organizations use cost information to determine

Different types of organizations have different types

A single cost can be classified and used in several

Overview of Cost Classifications:

Cost Traceability: Control cost by determining which

Direct costs: costs that can be conveniently and

Indirect costs: costs that cannot be conveniently and

Cost Behavior : Calculate the number of units that

Variable costs: costs that changes in direct

Fixed costs: costs that remain unchanged regardless

Value-adding Attributes: Identify the costs of

A value-adding cost: the cost of an activity that

A nonvalue-adding cost : the cost of an activity that

Financial Reporting: Classify costs for the

The key to preparing an income statement or

1. Cost of Sales = Net Cost of Services Sold

2. Cost of Goods Sold = Beginning Merchandise

3. Cost of Goods Sold = Beginning Finished Goods

4. Sales – Cost of Sales or Cost of Goods Sold = Gross

Statement of cost of goods manufactured as being

Example: see page 63

 See Table on page 66

Finished Goods Inventory:

Work in Process Inventory:

Work in Process Inventory, Ending Balance = Work in

Cost allocation methods comprise an important

Four types of cost objectives:

Producing departments are where employees

Service departments exist only to

Direct costs can be physically traced to each department.

Indirect costs must be allocated.

Many companies develop allocation

All organizations accumulate costs for their

Increasingly, companies measure and manage

Customer related costs include:

An accounting system will assign to a department’s output

A cost driver that has a logical, cause-effect relationship

School of Business School of Engineering

1. Divide the costs in each

Direct costs Indirect costs

2. Assign direct costs to the appropriate

3. Select one or more cost pools and related

Indirect departmental costs

Cost Cost Cost

Product Product Product

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