Learning Objectives
After studying Chapter 1, you should be able to:

• Identify and give examples of each of the three basic manufacturing cost categories.
• Distinguish between product costs and period costs and give examples of each.
• Prepare an income statement including calculation of the cost of goods sold.
• Prepare a schedule of cost of goods manufactured.
• Define and give examples of variable costs and fixed costs.
• Define and give examples of direct and indirect costs.
• Define and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.
• (Appendix 1A) Identify the four types of quality costs and explain how they interact.

Chapter 1

Managerial accounting is concerned with providing information to managers—that is, people inside an organization who direct and control its operations. In contrast, financial accounting is concerned with providing information to stockholders, creditors, and others who are outside an organization. Managerial accounting provides the essential data with which organizations are actually run. Financial accounting provides the scorecard by which a company’s overall past performance is judged by outsiders.

Managerial accountants prepare a variety of reports. Some reports focus on how well managers or business units have performed—comparing actual results to plans and to benchmarks. Some reports provide timely, frequent updates on key indicators such as orders received, order backlog, capacity utilization, and sales. Other analytical reports are prepared as needed to investigate specific problems such as a decline in the profitability of a product line. And yet other reports analyze a developing business situation or opportunity. In contrast, financial accounting is oriented toward producing a limited set of specific prescribed annual and quarterly financial statements in accordance with generally accepted accounting principles.

Summary

LO1 Identify and give examples of each of the three basic manufacturing cost categories.
Manufacturing costs consist of two categories of costs that can be conveniently and directly traced to units of product—direct materials and direct labor—and one category that cannot be conveniently traced to units of product—manufacturing overhead.

LO2 Distinguish between product costs and period costs and give examples of each.
For purposes of valuing inventories and determining expenses for the balance sheet and income statement, costs are classified as either product costs or period costs. Product costs are assigned to inventories and are considered assets until the products are sold. A product cost becomes an expense—cost of goods sold—only when the product is sold. In contrast, period costs are taken directly to the income statement as expenses in the period in which they are incurred.

In a merchandising company, product cost is whatever the company paid for its merchandise. For external financial reports in a manufacturing company, product costs consist of all manufacturing costs. In both kinds of companies, selling and administrative costs are considered to be period costs and are expensed as incurred.

LO3 Prepare an income statement including calculation of the cost of goods sold.
See Exhibit 1-4 for examples of income statements for both a merchandising and a manufacturing company. In general, net operating income is computed by deducting the cost of goods sold and operating expenses from sales. Cost of goods sold is calculated by adding purchases to the beginning merchandise or finished goods inventory and then deducting the ending merchandise or finished goods inventory.

LO4 Prepare a schedule of cost of goods manufactured.
See Exhibit 1-6 for an example of a schedule of cost of goods manufactured. In general, the cost of goods manufactured is the sum of direct materials, direct labor, and manufacturing overhead incurred during the period.

LO5 Define and give examples of variable costs and fixed costs.
For purposes of predicting cost behavior—how costs will react to changes in activity—costs are commonly categorized as variable or fixed. Variable costs, in total, are strictly proportional to activity. Thus, the variable cost per unit is constant. Fixed costs, in total, remain at the same level for changes in activity within the relevant range. Thus, the average fixed cost per unit decreases as the number of units increases.

LO6 Define and give examples of direct and indirect costs.
A direct cost is a cost that can be easily and conveniently traced to a costing object. Direct materials is a direct cost of making a product. An indirect cost is a cost that cannot be easily and conveniently traced to a cost object. The salary of the administrator of a hospital is an indirect cost of serving a particular patient.

LO7 Define and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.
The concepts of differential cost and revenue, opportunity cost, and sunk cost are vitally important for purposes of making decisions. Differential costs and revenues are the cost and revenue items that differ between alternatives. Opportunity cost is the benefit that is forgone when one alternative is selected over another. Sunk cost is a cost that occurred in the past and cannot be altered. Differential costs and opportunity costs should be carefully considered in decisions. Sunk costs are always irrelevant in decisions and should be ignored.

The various cost classifications discussed in this chapter are different ways of looking at costs. A particular cost, such as the cost of cheese in a taco served at Taco Bell, can be a manufacturing cost, a product cost, a variable cost, a direct cost, and a differential cost—all at the same time. Taco Bell can be considered to be a manufacturer of fast food. The cost of the cheese in a taco would be considered a manufacturing cost and, as such, it would be a product cost as well. In addition, the cost of cheese would be considered variable with respect to the number of tacos served and would be a direct cost of serving tacos. Finally, the cost of the cheese in a taco would be considered a differential cost of the taco.