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Lecture 2

COMMERCE 2AB3 Lecture 2: Chapter 2.pdf

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Mohamed Shehata

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Chapter 2 - Lecture Notes Dr. Mohamed Shehata
Chapter 2
Introduction to Cost Terms, Concepts, and Classifications
A cost is the monetary value of economic resources (e.g., money) that an entity sacrificed in order
to acquire assets or service for the purpose of using them to produce & sell a product/ service or to
purchase merchandise for resale. Examples of costs that may occur by a manufacturing company
include purchase of raw materials, labor, equipment, rent, and production facilities.
It should be noted that the terms 'cost' and 'expense' are incorrectly used interchangeably. In
accounting, however, the two terms have quite different meanings. While costs are assets that
belong to the balance sheet, expenses are assets consumed or used up in the process of generating
revenues. Expenses, therefore, should be matched with revenues in the income statement.
Example 1:
ABC Co. started business on Jan. 1, 2012 to produce and sell a product called Alpha. On January
2nd 2012, ABC purchased raw materials for $75,000 and equipment for $100,000 to be used in
producing Alpha. The two transactions appear on the Balance Sheet as follows:
Balance Sheet (January 2nd 2012)
During January 2012, ABC Co. produced 5,000 units of Alpha and incurred the following
o Raw Materials Cost ------------------------------ $25,000
o Labor (wages) Cost ------------------------------ $15,000
o Machine Depreciation Cost ------------------ $20,000
Total production (manufacturing) Costs ----- $60,000
o Selling Expenditure --------------------------- $ 14,000
o Administrative Expenditure ------------------ $11,000
On January 29, 2012, ABC Co. sold 4,000 units @ $25 per unit.
1. Prepare the relevant asset items on the Balance Sheet on January 29 prior to the sale of Alpha.
2. Prepare the Income Statement on January 31, 2012.
3. Prepare the relevant asset items on the balance sheet on January 31, 2012
Income Statement (1/31/2012) B/S (1/29/2012)
B/S (1/31/2012)
Materials (Inventory) $ 75,000
Equipment $100,000
Sales Revenues $ -------------
- (CGS) (-------------)
Gross Profit -----------
- Selling Expense ( ----------- )
- Administrative Expenses ( ----------- )
Net Income -----------
Materials (Inventory) $ -----------
Equipment $ -----------
Finished Goods Inventory $-----------
Materials (Inventory) $ -----------
Equipment $ -----------
Finished Goods Inventory $ -----------
Chapter 2 - Lecture Notes Dr. Mohamed Shehata
Product Costing:
Product costing refers to the process of calculating the cost of production for the purpose of
determining the Cost of Goods Sold (CGS) for income determination and cost of Ending Inventory
to prepare the balance sheet.
Product Costs vs. Period Costs:
Product Costs
Product costs (Inventoriable Costs) are the costs charged (added) to the units produced as they are
incurred (i.e., inventoried). They become part of the cost of goods produced and treated as inventory
(i.e., asset) until they are sold. When the production is sold, they become cost of goods sold and then
charged to the income statement at the end of the period as expense. This can result in a delay of
one or more periods between the time in which the cost is incurred and when it appears as an
expense on the income statement.
Period Costs
Period costs are expensed in the time period in which they are incurred. In other words, period costs
are charged directly to the Income Statement without going to it through the balance sheet. All
selling and administrative (S&A) costs are typically considered to be period costs.
Cost Object:
A cost object is anything of interest for which a separate measurement of cost is needed
(e.g., cost of a product, a process, a service, activity, organizational unit, or a customer).
Cost objects can vary in size from an entire company, to a division, or down to a single
product or service.
Cost Driver:
A cost driver is any activity or factor that causes the total amount spent on a cost object to
change. For example, the total cost of renting a car could be driven by all or some of the
following factors: number of miles driven, number of days the car is rented, the type and/size
of the car, etc.
Change in the cost driver must result in a changes in the total costs incurred.
In order for managers to control or minimize costs, it is necessary to identify the correct cost
Chapter 2 - Lecture Notes Dr. Mohamed Shehata
Types of Cost drivers:
There are three types of cost drivers:
a. Volume-based cost drivers are related to the amount produced /sold or quantity of
service provided.
b. Activity-based cost drivers (ABC) are developed at a detailed level of operations using
activity analysis. Cost drivers are determined for each activity
c. Structural cost drivers are based on strategic decision (choice). Scale, production
capacity, and technology are example of choices that managers should considered for the
purpose of improving competitive position
Example 2:
List some of the major cost drivers that are expected to affect the total amount of money that you
may spend on renting a car for a period of time?
Size of the car (Full size, medium, small), Type of the car (Luxury, regular,
economy), # of days, # of miles driven, type of gas (super, regular), parking, etc.
Cost Behavior
For the purposes of planning, control, and decision making, managers need to understand
TOTAL amount spent on a particular cost object reacts to changes in a cost driver as measured, for
example, by production or sales volume. In order to understand this behavior (i.e., the type of
relationship), we need to perform cost estimation.
Cost estimation
Cost estimation is the process of estimating the parameters of a cost function that explains how the
total costs spent on a cost object response to the changes in its cost driver(s). The purposes of cost
estimation are to:
(1) identify the key cost drivers for each cost object to help managers control costs
(2) measure the variable and/or fixed components of the cost item so as to help managers
make correct decisions, and
(3) predict the expected future amount of the cost object so as to help managers correctly
plan for the future budget.
Cost Accumulation
Cost accumulation is the process of tracking, recording and collecting cost data in an organized
Cost Pool
A cost pool is a group of accumulated cost items that have similar attributes and are driven by the
same cost driver.
Three possible cost behaviour patterns: Pure variable, Pure fixed, or Mixed