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 exhibit1_4 for examples of income statements for both a merchandising and a manufacturing company. Net operating income is computed by deducting the cost of goods sold and selling and administrative expenses from sales. In a merchandising company, cost of goods sold is calculated by adding purchases to the beginning merchandise inventory and then deducting the ending merchandise inventory. In a manufacturing company, cost of goods sold is computed by adding the cost of goods manufactured to the beginning finished goods inventory and then deducting the ending finished goods inventory.

LO4   Prepare a schedule of cost of goods manufactured. The cost of goods manufactured is the sum of direct materials, direct labor, and manufacturing overhead costs associated with the goods that were finished during the period. See Exhibit 1-6 for an example of a schedule of cost of goods manufactured.

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. Total variable costs are strictly proportional to activity. Thus, the variable cost per unit is constant. Total fixed costs remain the same when the level of activity fluctuates 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 such as direct materials is a cost that can be easily and conveniently traced to a cost object. An indirect cost is a cost that cannot be easily and conveniently traced to a cost object. For example, 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 refer to the costs and revenues 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 are relevant in decisions and should be carefully considered. 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 essentially manufactures fast food. Therefore the cost of the cheese in a taco would be considered a manufacturing cost as well as a product cost. 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.