CHAPTER 3

COST FLOWS AND COST TERMINOLOGY

TRUE/FALSE

1. To comply with GAAP, an income statement must separate direct and indirect costs.
LO1 – False To comply with GAAP, an income statement must separate product and period costs.

2. Product costs always appear “below the line” for gross margin.
LO1 – False Product costs always appear “above the line” for gross margin.

3. Period costs are all costs that are not product costs.
LO1 – True

4. Period costs are added to gross margin to arrive at profit before taxes.
LO1 – False Period costs are subtracted from gross margin to arrive at profit before taxes.

5. GAAP provides considerable flexibility regarding reporting formats.

LO1 – True

6. Service firms are distinguished from other firms in that the products service firms offer are not
tangible or storable.
LO2 – True

7. The GAAP income statement combines controllable with non-controllable costs and fixed costs with
variable costs.
LO2 – True

8. Period costs contain controllable, but not non-controllable costs.

LO2 – False Period costs contain controllable and non-controllable costs.

9. It frequently is vital to modify accounting reports and use non-financial data to estimate the
controllable costs and benefits of a decision option.
LO2 – True

10. The cost of providing services might include depreciation on equipment.

LO2 – True

11. Unlike service firms, merchandising firms maintain an inventory of goods that they buy and sell.
LO3 – True

12. For financial reporting purposes, merchandising firms expense the cost of items when they purchase
them.
LO3 – False For financial reporting purposes, merchandising firms expense the cost of items when
they are sold, not when they purchase them.

13. As with service firms, period costs appear below the line for gross margin.
LO3 – True

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14. The cost of purchasing goods from suppliers does not include the cost of transportation.
LO3 – False The cost of purchasing goods includes not only the amounts paid to suppliers, but also
the cost of transportation and the cost of preparing the goods for sale.

15. The cost flows in merchandising firms resemble the flows for service firms.
LO3 – True

16. The total of all the indirect manufacturing inputs are sometimes referred to as manufacturing
allocation.
LO4 – False The total of all the indirect manufacturing inputs are sometimes referred to as
manufacturing overhead.

17. Product costs are often referred to as inventoriable costs because these are the costs that firms
attach to inventories of work in process and finished goods.
LO4 – True

18. Once the production process is completed, firms transfer finished work physically from work-in-
process inventory to raw materials inventory.
LO4 – False Once the production process is completed, firms transfer finished work physically from
work-in-process inventory to finished goods.

19. The sum of labor and overhead is referred to as conversion costs.

LO4 – True

20. The terms cost of goods sold and costs of goods manufactured are used interchangeably.
LO4 – False Costs of goods sold represents the product costs associated with the items sold during
the year. It is not necessarily the same as the cost of goods manufactured during the year.

21. Overhead costs are direct and, as such, are traceable to each product.
LO5 – False Overhead costs are indirect and, as such, are not traceable to each product.

22. A cost allocation is a procedure that allocates, or distributes, a common cost.

LO5 – True

23. Cost objects are items or entities to which we allocate the costs from overhead.
LO5 – False Cost objects are items or entities to which we allocate the costs in the cost pool.

24. The proportion of cost allocated to a cost object equals the proportion of driver units in that cost
object.
LO5 – True

25. The overhead allocated to an individual unit or product line is the number of driver units contained
in that unit or product line times the overhead rate per driver unit.
LO5 – True

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MULTIPLE CHOICE

26. The costs associated with getting products and services ready for sale are known as:
A. Sales costs.
B. Conversion costs.
C. Opportunity costs.
D. Product costs.
E. Costs of goods sold.
LO1 – D

27. The costs of management salaries that are not a part of the costs of providing programs or services
are referred to as:
A. Period costs
B. Product costs.
C. Cost of goods sold.
D. Conversion costs.
E. None of the above.
LO1 – A

28. The matching principle in GAAP requires that we separate:

A. Conversion costs and overhead.
B. Product costs and period costs.
C. Selling and administrative costs.
D. Controllable and non-controllable costs.
E. None of the above.
LO1 – B

29. Maintenance on factory equipment is a(n):

A. Period cost.
B. Overhead cost.
C. Administrative cost.
D. Product cost.
E. Both B and D are correct.
LO1 – D

30. Which of the following statements relating to period costs is not correct?
A. Period costs are all costs that are not product costs.
B. Period costs always appear below the line for gross margin.
C. Period costs are not separated from product costs in GAAP income statements.
D. Both A and B are incorrect.
E. A, B, and C are incorrect.
LO1 – C

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31. Acme Manufacturing Company’s controller was classifying costs for the most recent financial
statement period. Which of the following should be excluded from the calculation of gross margin?
a. Factory worker wages.
b. Materials used in assembling a product.
c. Conveyer belt maintenance for production of all products.
d. Marketing brochure for the company’s new product.
LO1 – Post-test – D

32. Which of the following is most likely a product cost?

a. Advertising expense
b. Sales commissions for the current month
c. Cardboard packaging for the product
d. Janitorial expense for the administrative offices
LO1 – Pre-test – C

33. Grand Rapids Rafting Company recorded the following data for the month of October:
Cost of beginning inventory $46,000
Cost of ending inventory $32,000
Cost of goods sold $122,000
Inventory purchases for the month of October total:
a. $108,000
b. $136,000
c. $200,000
d. $44,000
LO1 – Self-test – A

34. Property taxes on a manufacturing plant is an example of:

Product Cost Manufacturing
Overhead
A. No Yes
B. No No
C. Yes No
D. Yes Yes
LO1 – Self-test – D

35. If a company’s revenue is $530,000, profit before taxes is $98,000, and product costs are $390,000
then:
a. The company’s gross margin totals $140,000.
b. The company’s period costs total $140,000.
c. The company’s period costs cannot be determined.
d. The company’s contribution margin totals $140,000.
LO1 – Self-test – A

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36. The income statement for a service firm distinguishes between which of the following costs?
A. Cost of goods manufactured and conversion costs.
B. Costs of providing services and product costs.
C. Cost of providing service and selling and administrative costs.
D. Selling and administrative costs and period costs.
E. None of the above.
LO2 – C

37. A GAAP income statement combines which of the following costs?

A. Fixed costs with variable costs.
B. Controllable costs with non-controllable costs
C. Costs of providing services and period costs.
D. A and B only.
E. A, B, and C.
LO2 – D

38. What distinguishes services firms from other firms?

A. Service firms do not incur depreciation costs.
B. Service firms do not use capital resources to perform their functions.
C. The products service firms offer are not tangible or storable.
D. Human capital is an important resource for service firms, but not for other firms.
E. None of the above.
LO2 – C

39. Which of the following is not an example of a service firm?

a. Delta Airlines.
b. Blankenship and Hobbs, Attorneys.
c. First State Bank.
d. Hilton Hotels.
e. All of the above are service firms.
LO2 – E

40. Tomba Civil Engineers’ manager is attempting to calculate its cost of providing services to clients. Its
profit before taxes for January is $4,000, and it’s selling and administration costs are $8,000, service
revenue is $20,000. How much is its cost of providing service?
a. $12,000
b. $4,000
c. $8,000
d. $20,000
LO2 – Post-test – C

41. C & C Power Lines is a subcontractor that works on public utilities. Which of the following is a key
characteristic that makes it distinctively a service company?
a. It does not maintain inventories.
b. Its products are tangible.
c. Its product costs appear below the line in computing gross margin.
d. All of its costs are period costs.
LO2 – Pre-test – A

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42. Office rent is an example of a (an):

a. Administrative cost.
b. Product cost.
c. Conversion Cost.
d. Costs of providing product or service.
e. Direct cost.
LO3 – A

43. The cost of purchasing goods from suppliers includes all of the following costs except:
a. Cost of transportation.
b. Amounts paid to suppliers.
c. Sales commissions.
d. Costs of preparing goods for sale.
e. All of the above are included in the cost of purchasing goods from suppliers.
LO3 – C

44. Which of the following inventory equations produces the Cost of Goods Sold?
a. Cost of beginning inventory + cost of goods purchased during period – cost of ending inventory.
b. Cost of ending inventory + cost of goods purchased during period – cost of beginning inventory.
c. Cost of beginning inventory – cost of goods purchased during the period.
d. Cost of ending inventory – cost of goods purchased during the period.
e. Cost of ending inventory + cost of goods purchased during the period.
LO3 – A

45. Which of the following items is reported on the balance sheet prior to being expensed on the
income statement as a product cost?
a. Inventory.
b. Insurance.
c. Sales commissions.
d. Utility charges.
LO3 – Post-test - A

46. Gate Grocery’s most popular candy bars cost $0.50 each and sell for $0.75. Management
determined that it had purchased 3,000 candy bars in February. It began February with 200 bars and
had 150 remaining at the end of February. How much is cost of goods sold for February?
a. $1,475
b. $2,287.50
c. $3,050
d. $1,525
LO3 – Pre-test – D

47. Prime costs are:

A. The sum of materials and labor costs.
B. The sum of labor and manufacturing overhead.
C. The sum of fixed and variable overhead costs.
D. The sum of material, labor, and overhead costs.
LO3 – Self-test – A

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48. The cost of direct labor in a manufacturing plant is an example of:

Conversion Cost /Period Cost
A. No Yes
B. No No
C. Yes No
D. Yes Yes
LO3 – Self-test – C

49. The following costs were incurred in November:

Direct materials $16,000
Direct labor 8,000
Manufacturing overhead 10,000
Selling expenses 4,000
Administrative expenses 5,000

Prime costs during the month totaled:

A. $34,000
B. $24,000
C. $43,000
D. $9,000
LO3 – Self-test – B

50. Product costs are also known as:

a. Prime costs.
b. Conversion costs.
c. Period costs.
d. Inventoriable costs
LO3 – Self-test – D

51. The Peterson Company incurred the following costs in the month of May:
Direct materials purchased $12,000
Commissions paid to salespeople $5,000
Direct labor paid $9,000
Manufacturing plant utility costs $19,000
Advertising costs $2,000

The company’s product costs total:

A. $45,000
B. $47,000
C. $40,000
D. $42,000
LO3 – Self-test – C

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52. Product costs are also referred as:

a. Mixed cost.
b. Selling and administrative costs.
c. Inventoriable costs.
d. Volume cost.
e. Break-even cost.
LO4 – C

53. Product costs include which of the following costs?

a. Manufacturing overhead costs and selling and administrative costs.
b. Variable manufacturing costs and manufacturing overhead costs.
c. Common costs and special costs.
d. Period costs and common costs.
e. Variable costs only.
LO4 – B

54. Manufacturing overhead includes which of the following costs?

a. Fixed costs only.
b. Variable costs only.
c. Conversion costs and direct labor.
d. Variable overhead and fixed overhead.
e. Common costs and special costs.
LO4 – D

55. Which of the following are the inputs manufacturers use to make their product?
a. Direct material, direct labor, and manufacturing overhead.
b. Period costs and product costs.
c. Conversion costs and direct labor.
d. Common costs and special costs.
e. Direct material, direct labor, and period costs.
LO4 – A

56. Packaging materials is an example of:

a. Fixed overhead.
b. Direct material.
c. Variable overhead.
d. Period cost.
e. Prime cost.
LO4 – C

57. Prime costs include:

a. Direct material, direct labor, and manufacturing overhead.
b. Direct material and direct labor.
c. Direct labor and manufacturing overhead.
d. Direct material and manufacturing overhead.
e. Variable overhead and fixed overhead.
LO4 – B

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58. In a typical production process, the physical flows for a manufacturer are:
a. Work-in-Process Inventory→Material Inventory→Finished Goods Inventory→Cost of Goods
Sold.
b. Material Inventory→Cost of Goods Sold→Finished Goods.
c. Material Inventory→Work-in-Process inventory→Finished Goods Inventory→Cost of Goods
Sold.
d. Finished Goods Inventory→Cost of Goods Sold→Material Inventory
e. None of the above.
LO4 – C

59. Attributes that we can measure for each cost object is referred to as:
a. Cost Driver.
b. Allocation Basis.
c. Cost Pool.
d. Both A and B.
e. A, B, and C.
LO4 – D

60. Which of the following includes all the components of conversion costs?
a. Direct materials and direct labor.
b. Prime costs plus fixed overhead.
c. Variable overhead and fixed overhead.
d. Direct labor plus capacity costs
LO4 – Post-test – D

61. Billings Company’s plant manager is trying to better understand his plant’s inventory workflow. He
determined that $10 million was spent on raw materials, $2 million on direct labor and $3 million on
manufacturing overhead. If raw materials beginning and ending inventories are $2 million and $1
million, respectively, and work-in-process beginning and ending inventories are $6 million and $4
million respectively, how much is cost of goods manufactured?
a. $17 million.
b. $16 million.
c. $15 million.
d. $18 million.
LO4 – Post-test – D

62. Which of the following is the best example of prime costs for Sharp Edge Mowers?
a. Sales commissions and maintenance on the machine that tightens bolts on lawn mowers during
production.
b. Assembly line wages and the cost of tires to be installed on newly assembled lawnmowers.
c. The general manager’s salary and the janitorial expense for executives’ offices.
d. The interest cost on the manufacturing building and the wages paid for the quality control
inspector for the assembly line
LO4 – Pre-test – B

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63. Company’s controller is calculating the current month’s cost of goods manufactured. Which of the
following should be considered as part of the calculation?
a. Direct labor and indirect costs.
b. Indirect labor and commission expenses.
c. Manufacturing overhead and the corporate vice president’s salary.
d. Cost of materials used and finished goods inventory.
LO4 – Pre-test – A

64. Which of the following would most likely not be included as manufacturing overhead in a plant
which produces cars?
a. Glass used to make windshields.
b. Salary paid to manufacturing plant custodians.
c. Manufacturing plant utility expenses.
d. Real estate taxes on the manufacturing plant
LO4 – Self-test – A

65. The Flynn Company began the period with $15,000 worth of raw materials. During the period they
purchased an additional $17,000 worth of materials and issued $24,000 of materials for production.
In addition, the company paid $8,000 for direct labor costs and $6,000 in manufacturing overhead
costs. The balance in the company’s Work-in Process inventory account at the end of the period
was:
a. $38,000
b. $46,000
c. $32,000
d. $40,000
LO4 – Self-test – A

66. The Clarke Company provided the following information for the month of December:
Beginning work-in-process $12,000
Ending work-in-process $9,000
Direct labor/materials used $14,000
Manufacturing overhead $7,000

The company’s cost of goods manufactured for December is:

A. $42,000
B. $24,000
C. $33,000
D. $28,000
LO4 – Self-test – B

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67. The Merchant Tire Company provided the following information for the month of February:
Cost of goods manufactured $147,000
Beginning finished goods inventory $23,000
Cost of goods sold $129,000

The company’s balance in their finished goods inventory account at the end of February is:
A. $23,000
B. $18,000
C. $5,000
D. $41,000
LO4 – Self-test – D

68. Bass Boss Manufacturing Company manufactures two types of bass boats. Bass Boss provides the
following data, pertinent to allocating its annual overhead cost of $435,000:

Bass Boss Product Boss Boss

Hog Bear
Units per year 15,000 20,000
Machine hours/unit 3.0 5.0

Materials cost/unit $1,500 $2,000

Labor cost/unit $ 800 $1,000

What is the cost pool for Bass Boss?

a. Annual overhead costs.
b. Units per year.
c. Machine hours/unit.
d. Material costs/unit.
e. Labor costs/unit.
LO5 – A

69. Bass Boss Manufacturing Company manufactures two types of bass boats. Bass Boss provides the
following data, pertinent to allocating its annual overhead cost of $435,000:

Bass Boss Product Boss Boss

Hog Bear
Units per year 15,000 20,000
Machine hours/unit 3.0 5.0

Materials cost/unit $1,500 $2,000

Labor cost/unit $ 800 $1,000

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What are the cost objects?

a. Annual overhead costs.
b. Boss Hog and Boss Bear.
c. Units per year.
d. Machine hours/unit.
e. Material and Labor costs/unit.
LO5 – B

70. Bass Boss Manufacturing Company manufactures two types of bass boats. Bass Boss provides the
following data, pertinent to allocating its annual overhead cost of $435,000:

Bass Boss Product Boss Boss

Hog Bear
Units per year 15,000 20,000
Machine hours/unit 3.0 5.0

Materials cost/unit $1,500 $2,000

Labor cost/unit $ 800 $1,000

What are the cost drivers?

a. Overhead costs; Units per year.
b. Boss Hog; Boss Bear.
c. Overhead costs; Machine hours/unit.
d. Machine hours/unit; Material cost/unit; Labor cost/unit
e. Units per year.
LO5 – D

71. Bass Boss Manufacturing Company manufactures two types of bass boats. Bass Boss provides the
following data, pertinent to allocating its annual overhead cost of $435,000:

Bass Boss Product Boss Boss

Hog Bear
Units per year 15,000 20,000
Machine hours/unit 3.0 5.0

Materials cost/unit $1,500 $2,000

Labor cost/unit $ 800 $1,000

Determine the allocation rate for assuming the cost driver is machine hours/unit.
a. $3 per machine hour
b. $12.43 per machine hour
c. $54,375 per machine hour
d. $4.35 per machine hour
e. $$5,000 per machine hour
LO5 – A $435,000 ÷ ((15,000 x 3) + (20,000 x 5))

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72. Bass Boss Manufacturing Company manufactures two types of bass boats. Bass Boss provides the
following data, pertinent to allocating its annual overhead cost of $435,000:

Bass Boss Product Boss Boss

Hog Bear
Units per year 15,000 20,000
Machine hours/unit 3.0 5.0

Materials cost/unit $1,500 $2,000

Labor cost/unit $ 800 $1,000

What is the amount of manufacturing overhead allocated to Boss Bear?

a. $435,000
b. $217,500
c. $100,000
d. $300,000
e. $135,000
LO5 – D (20,000 x 5) x $3

73. Which of the following costs are added to work-in-process during the period?
a. Raw materials.
b. Labor.
c. Administrative costs.
d. Both A and B.
e. A, B, and C
LO4 – D

74. The allocation rate is $4; the cost object is boats; and the number of boats is the cost driver. The
cost pool is $40. There are 4 red boats and 6 blue boats produced. How much cost is allocated to red
boats?
a. $16
b. $4
c. $40
d. $20
LO5 – Post-test - A

75. Harms Shoe Company applies manufacturing overhead based on the number of units as the cost
driver. Information concerning costs for July follows:

Direct labor costs 800 hours @ $14

Manufacturing overhead $8,000
Direct materials $45,000

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How much is the unit product cost if 1,000 units are produced?
A. $8.00
B. $64.20
C. $53.00
D. $45.00
LO5 – Post-test – B

76. Which of the following is a cost pool?

a. Items that have costs allocated to them.
b. Attributes that are measured for each cost object.
c. The total costs to allocate
d. The rate used to allocate costs
LO5 – Pre-test – C

77. Harms Shoe Company applies manufacturing overhead based on direct labor hours as the allocation
volume. Information concerning manufacturing overhead and labor for July follows:

Estimated direct labor 6,100 hours @ $14.20

Estimated manufacturing overhead $277,184

How much overhead will be allocated during July to products with a direct labor of 5 hours?
a. $71.00
b. $45.44
c. $16.00
d. $227.20
LO5 – Pre-test – D

78. The SurferDude Company manufactures long and short surfboards. The company incurred
manufacturing overhead costs of $210,000 in March. They have decided to allocate these costs
based on units produced. In March the company produced 8,000 longboards and 6,000
shortboards. The amount of overhead allocated to each product, respectively, would be:
Longboards Shortboards
A $120,000 $90,000
B. $90,000 $120,000
C. $105,000 $105,000
D. $ 80,000 $60,000
LO5 – Self-test – A

79. When making decisions involving unit product costs, a company should:
A. Always consider all manufacturing overhead costs.
B. Always excluded all manufacturing overhead costs.
C. Consider only the variable portion of manufacturing overhead costs.
D. Consider only the fixed portion of manufacturing overhead costs.
Self-test – C

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80. The Harvey Company has provided the following information about its only product when they sold
10,000 units (all items are per unit).
Revenue $15.00
Direct labor cost 1.50
Direct materials 2.00
Allocated manufacturing overhead 6.00
(1/3 is variable, 2/3 is fixed)
Selling and administrative 1.00
(1/2 is variable, ½ is fixed)
Profit before tax $4.50
For every additional unit sold above 10,000, the company’s profit before taxes will increase by:
A. $4.50 per unit
B. $9.00 per unit
C. $7.00 per unit
D. $11.50 per unit
Self-test – B

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Problems

1. The following are some of the costs incurred by a CPA firm relating to its tax practice.

Required:
Indicate by placing an “X” in the appropriate column whether each of the following items describes
a product cost (above the line for gross margin) or a period cost (below the line for gross margin.)

Product Period Type of Cost

a. _____ _____ Receptionist’s salary.

b._____ _____ Depreciation on tax preparation software.

c._____ _____ Cost of adding annual tax update to tax preparation

software.

d._____ _____ Tax preparers’ salaries.

e_____ _____ Rent for office space.

2. Walker Consulting specializes in helping small companies protect their assets from employee theft.
Walker has provided the following data relating to its current year:

Revenues $850,000
Gross margin $560,000
Profit before taxes $300,000

Walker’s period costs are made up 30 percent marketing costs and 70 percent administrative costs.

Required:
a. Complete a GAAP income statement.

b. What is the firm’s cost to provide service?

c. What are its general and administrative costs?

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 Cost Flows and Cost Terminology

3. The following is a condensed income statement for Watson’s Bicycle Sales, a retail entity specializing
in racing bicycles.

Watson’s Bicycle Sales

GAAP Income Statement
Revenue $425,000
Beginning inventory January 1 $15,000
Purchases ?
Ending inventory, December 31 $11,500
Cost of goods sold ?
Gross Margin $235,000
Selling and administrative costs ?
Profit before taxes $82,000

Required:
a. Determine the cost of purchases.

b. Determine the selling and administrative costs.

4. Mitchell’s Small Engine Repair Company’s accounting records show the following information
relating to its inventories:

Beginning Raw Materials Inventory $ 45,000

Raw Materials Purchased during year 550,000
Ending Raw Materials Inventory 42,000
Beginning Work In Process Inventory 95,000
Manufacturing costs charged to operations during year 900,000
Ending Work In Process Inventory 125,000
Beginning Finished Goods Inventory 90,000
Ending Finished Goods Inventory 65,000

Required:
a. What was the cost of raw materials issued into work in process during the year?

b. What is the cost of goods completed and transferred to finished goods during the year?

c. Calculate the cost of goods sold during the year.

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5. Virgo is a manufacturer of office furniture. Virgo uses large molding machines to produce its
fiberglass molded chair seats. The chairs are then covered with a protective glaze, connected to the
chair legs, packaged and shipped. The following data pertain to setting up a molding machine.
Annual setup costs total $150,000. The machine has to be set up for the following models: child’s
desk chair, regular desk chair, super-model desk chair.

Number of Hours per Total number of setup

Model
setups per year setup hours for the year
Child’s desk chair 15 8 120
Regular desk chair 30 12 360
Super-model desk chair 5 20 100
Total 50 n/a 580

Required:
a. Suppose Virgo allocates setup costs to products using the number of setups as the allocation
basis. What is the setup cost allocated to the super-model desk chair?

b. Suppose Virgo allocates setup costs to products using the total number of setup hours as the
allocation basis. What is the setup cost allocated to the regular desk chair?

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 Cost Flows and Cost Terminology

Problem Solutions

1. Product versus period cost (LO1)

a. Period
b. Product
c. Product
d. Product
e. Period

2. GAAP Income Statement (LO2)

Walker Consulting
GAAP Income Statement for Current Year
Revenue $850,000
Cost of Providing Services 290,000
Gross Margin $560,000
Marketing costs 78,000
Administrative costs 182,000
Profit before Taxes $300,000

3. Cash flow in merchandising entity(LO3)

a. Cost of purchases.

$425,000 (revenue) - $235,000 (gross profit) = $190,000 cost of goods sold.

$190,000 (cost of goods sold) + $11,500 (ending inventory) - $15,000 (beginning inventory) =
$186,500 cost of purchases.

b. Selling and administrative costs.

$235,000 (gross margin) - $82,000 (profit before taxes) = $153,000 selling and administrative
costs.

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4. Cost flows in manufacturing (LO4)

a. Cost of raw materials charged to work in process:
$553,000 = $45,000 (beginning inventory) + $550,000 (purchases) - $42,000 (ending inventory)

b. Cost of goods completed and transferred to finished goods during the year:
$870,000 = $95,000 (beginning inventory) + $900,000 (manufacturing costs charged to
operations) = $125,000 (ending inventory)

c. Cost of goods sold during the year:

$895,000 = $90,000 (beginning inventory) + $870,000 (goods transferred in) - $65,000 (ending
inventory)

5. Allocation mechanics (LO5)

a. Setup cost allocated to the Super-model desk chair.
($150,000 costs/50 total number of setups) x 5 Super-model setups = $15,000

b. Setup cost allocated to the regular desk chair?

($150,000 costs/580 total setup hours) x 360 regular setup hours = $93,103.

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END OF CHAPTER HOMEWORK CONTENT

Short Answer

1. What is the difference between a product cost and a period cost?

2. What is the gross margin?

3. Why does GAAP require firms to distinguish between product and period costs?

4. What is the key characteristic of a service firm?

5. What is the key characteristic of a merchandising firm?

6. What is the inventory equation?

7. What is the key characteristic of a manufacturing firm?

8. Why do we frequently refer to materials and labor costs as being both direct and variable?

9. What is the difference between variable manufacturing overhead and fixed manufacturing
overhead?

10. Define the terms prime costs and conversion costs.

11. What are the four elements of every cost allocation?

12. Describe the two-step procedure for allocating costs.

13. What is the relation between the proportion of cost allocated to a cost object and the proportion of
driver units in the cost object?

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Solutions to Short Answer

1. (LO-1) Product costs are the costs associated with getting products and services for sale, whereas
period costs are not directly related to readying products and services for sale.

2. (LO-1) Revenues less product costs = revenues less cost of goods sold or cost of providing services.

3. (LO-1) The matching principle.

4. (LO-2) The products service firms offer are not tangible or storable.

5. (LO-3) Merchandising firms buy goods from suppliers and resell substantially the same products to
customers.

6. (LO-3) Cost of goods sold = cost of beginning inventory + cost of goods purchased during the period
– cost of ending inventory.

7. (LO-4) Manufacturing firms use labor and equipment to transform inputs such as raw materials and
components into outputs (finished goods).

8. (LO-4) Because they vary proportionally with production volume and can be traced directly to
products.

9. (LO-4) Variable manufacturing overhead varies proportionally with production volume, whereas
fixed manufacturing overhead does not change as production volume changes.

10. (LO-4) Prime costs equal the sum of direct materials and direct labor; conversion costs equal the
sum of direct labor and manufacturing overhead.

11. (LO-5) Cost pools, cost objects, cost driver (allocation basis), and allocation volume (denominator
volume).

12. (LO-5) Determine the allocation rate (overhead rate), and allocate the cost.

13. (LO-5) They are equal.

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Short Essay

1 Consider a consulting firm that completes large software projects that often take two or more years
to complete. What is the nature of inventory for such a firm? How should it value this inventory?

2 A restaurant converts inputs into substantially different outputs, a key characteristic of a

manufacturing firm. Yet, most would classify a restaurant as a service firm. How would you classify a
restaurant? Why?

3 Consider a firm such as U-Haul that supplies trucks that we could rent to move goods. (Ignore other
aspects of U-Haul’s operations.) To meet demand, which is usually seasonal and focused on a few
weeks each year, U-Haul keeps a large supply of trucks. Would you classify this firm as a service firm
or as a merchandising firm? What conclusions do you draw about the distinctions between service
and merchandising firms?

4 List three reasons why a merchandising firm holds inventory.

5 Should a retail firm include the cost of receiving and stocking goods when computing inventory
values?

6 Many merchandising firms charge the entire amount of transportation costs to cost of goods sold.
Other merchandising firms perform a year-end allocation to distribute the cost between the
inventory and cost of goods sold. How might firms justify not tracing transportation costs to
individual products and flowing these costs through the inventory accounts?

7 GAAP excludes most research and development costs from its definition of inventoriable costs. Why
do you believe GAAP mandates such a treatment?

8 Do you expect reported income and operating cash flows for a service firm to be close in
magnitude? Would your answer differ for a manufacturing firm? Why?

9 As you know, direct materials, direct labor, and manufacturing overhead are the three major
components of manufacturing costs. Expressing each part as a percentage of the total
manufacturing cost, how do you think the percentages of these costs have changed over the last 50
years?

10 Give an example of a manufacturing firm where labor is a major cost component. Give another
example in which labor is a negligible part of total manufacturing cost. How do you reconcile these
observations?

11 Assume a firm is deciding between labor hours and machine hours as a cost driver. When would
these drivers yield the same allocations?

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12 “Depreciation is nothing but an allocation of the purchase price over different accounting periods.”
Do you agree with this statement? If so, identify the elements of cost allocations (cost pool, cost
objects, cost driver, allocation volume) implicit in the computation of depreciation. If not, identify
differences between cost allocations and depreciation.

13 What is the most important asset for a professional services firm? Given your answer, what is a
reasonable basis for allocating the costs of this “asset” to individual projects?

14 Usually, we think of cost allocations as the process of splitting the cost of a shared resource

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Solutions to Short Essay

1. (LO-2) For long-term software and consultancy projects, typically one of two methods is followed.
The first is the completed contract method. Under this method, the company accumulates the
expenses incurred in the project in an “inventory” account, and states this inventory at cost in the
balance sheet as of the balance sheet date. In the year in which the project is completed, this cost is
then charged to the income statement against the revenues earned from the project (like cost of
goods sold for a manufacturing firm). The second method is the percentage completion method.
Under this method, expenses for each period are charged directly to the income statement each
year, and a proportional amount of the total project revenue is also recognized as income in that
year. In this case, there is no inventory account for the project.

2. (LO-2) Yes, a restaurant would typically be classified as a service firm because the benefit from the
“product” is not received by the customer over a period of time in the future. There is no transfer of
ownership of an “asset” as it were. Restaurant patrons receive the benefit of the eating experience
while being served at the restaurant site—this benefit cannot be bought and stored for future use
(the exception of course is “take-outs,” but we are not considering take-outs here).

3. (LO-2) We would classify U-Haul as a service firm as well for the same reason we consider
restaurants and hotels as service firms. Customers are essentially purchasing the right to use the U-
Haul truck for a specific period of time. This benefit is not storable and used at some future point in
time. As mentioned in the text, the products service firms offer are not tangible or storable like they
are for merchandising and manufacturing firms. U-Haul is a good example.

4. (LO-3) Merchandising firms hold inventories for the following reasons:

 To make products readily available whenever customers need them and shop for them.
If an item is not in stock, ordering, receiving and delivering it to the customer takes
time, and the product may reach the customer too late (think of grocery store items
such as milk, vegetables, and meat).
 Some items are available only in certain seasons, but there is demand throughout the
year. By stocking up when supply is available, merchandising firms can meet the
demand at other times.
 Often ordering and receiving in bulk quantities is a lot more cost effective for
merchandising firms than ordering in small quantities. Planning, handling and
transportation activities are a lot easier. For this reason, many suppliers offer bulk
discounts to induce merchandising firms to buy in large quantities and maintain
inventories at their own sites.

5. YLO-3) Yes, inventory is an asset, and the cost of an asset includes not just the purchase price but all
other expenses incurred to ready the asset for its intended purpose. Inventories are no exception.
Thus, the cost of inventory must include the cost of receiving and stocking goods. However,
including the cost of receiving and stocking goods poses an allocation problem for merchandizing
firms because these firms often purchase many different products in large quantities from the same
vendor. Any reasonable and equitable allocation procedure is acceptable.

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6. (LO-3) Some merchandising firms have very fast moving inventories because of the nature of the
business and the products involved. Grocery stores are a good example because they sell numerous
products with very short shelf lives. Allocating transportation and receiving costs to individual
products -- if done properly -- may result in accurate cost numbers for each product, but for such
firms, charging these costs directly to cost of goods sold is not likely to result in material distortions.

7. (LO-4) Research development expenditures typically provide benefits to companies at some future
in point in time. They are not part of the costs incurred to produce units in the inventory. Hence
they are not included in inventoriable costs. In general, GAAP requires that the costs of research and
development activities be expensed in the period in which they are incurred. The logic is that it is
difficult to ascertain future benefits that these expenditures may generate. So GAAP advocates a
“conservative” approach by advocating expensing of all research and development costs, and not
allowing any recognition of expected benefits.

8. (LO-4) Generally speaking, operating cash flows and income differ from each other because of non-
cash flows charges to income. One such non-cash item is depreciation. Depreciation is significant in
magnitude for manufacturing firms because these firms are capital incentive with property, plant
and equipment accounting for a major percentage of total assets. On the other hand, service firms
such as consulting firms, software and IT firms, are far more dependent on human resources. As we
know, human resources are not reported as assets under GAAP; the costs of human resources are
expensed as period costs in the periods in which they are incurred. Consequently, the depreciation
charge is much lower for service firms compared to manufacturing firms, and income and cash flows
tend to be closer to each other.

9. (LO-4) A noticeable trend in the last fifty years is the increase in the level of automation in almost
every sector of manufacturing. The direct labor content has decreased appreciably. This trend has
dramatically increased manufacturing overhead as a percentage of total costs because much of the
costs of automation get reflected in the increase in depreciation associated with property, plant and
equipment; and depreciation is included in the manufacturing overhead. Later, in Chapter 10, we
will learn that machine and equipment costs are better viewed as direct costs rather than overhead
from a decision making perspective.

10. (LO-4) Ship building and custom boat building require significant labor input. Another example
would be custom home building. Automobile manufacturing – once an extremely labor intensive
operation – is now highly automated, with very little labor content. Motorcycle manufacturing,
Harley-Davidson in particular, is highly automated.

11. (LO-5) In general, any two drivers would yield the same allocations if they are perfectly correlated
with one another. For example, suppose a company is producing two products, A and B. Product A
requires two hours of labor per unit, and one hour of machining per unit. Product B requires four
hours of labor per unit, and two hours of machining per unit. Let us say that the company expects to
produce 200 units of A and 100 units of B in a month, requiring 800 hours of labor and 400 hours of
machine time. Assume that the expected overhead costs are $8,000. If we use labor hour as the cost
driver, the overhead rate is $10 per labor hour (= $8,000/ 800 labor hours), and we would charge
$20 of overhead to a unit of A, and $40 to a unit of B. Suppose instead that we use machine hour as
the cost driver. In this case, the overhead rate is $20 (= $8,000/400 machine hours). Notice that the

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overhead charged per unit of A is again $20, and the overhead charged per unit of B is $40. The
reason we get the same allocations is that both products use labor and machine time in the same
proportion (two to one).

12. (LO-5) Yes, depreciation is a cost allocation procedure that allocates the purchase price of an asset
(e.g., a machine) over its life. The cost pool is the depreciation cost. If the objective of the allocation
is to compute product costs (either for inventory valuation or for decision making), the cost object
would be the product that the asset helps produce. The cost driver is time, and allocation volume
would be the useful life of the asset measured in number of years or number of hours.

13. (LO-5) The most important resource for a professional services firm such as a consultancy firm is
human resource in the form of the professional or the consultant providing the service. A
reasonable basis for allocating a consultant’s cost to a project or a job is to measure the amount of
the time individual spends on the job, and allocate his/her cost (e.g., salary, direct support and
overhead costs) in proportion to the time spend. For example, if a consultant is paid $400,000 in
annual salary, and works, on average, 2,000 hours a year, the application rate will be $200 per hour.
Therefore, if this individual spends 20 hours on an assignment, that assignment will be charged
$4,000.

14. (LO-5) Sometimes, situations do arise when revenues have to be allocated to different components
of a product offering that a company makes. Often, companies bundle products and services in
order to increase demand. Xerox is known to bundle sales of copiers with service agreements it
offers to maintain the copiers at the customers’ sites. Yet, from an organizational perspective,
making copiers and servicing them maybe be viewed as two distinct sets of activities for Xerox. It is
important for the company to know how profitable copiers themselves are, and how profitable is
servicing the copiers. Therefore, revenues from bundling these two aspects have to be allocated in a
reasonable way to help Xerox plan and manage their operations well.

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Exercises

1. The following are some of the costs incurred by a consulting firm. Salary paid to consultants Fee for
attending training seminar Salary to office administrator Corporate office rent Cost of general-
purpose software Travel to client site

Required:
Classify each cost as a product cost (above the line for gross margin) or a period cost (below the line for
gross margin).

2. The following data pertain to Boyd Associates, a consulting company.

Revenue $1,600,450
Gross margin 450,000
Profit before 275,400
taxes

Required:
Complete a GAAP income statement to determine (a) the firm’s cost to provide service and (b) its
marketing and administration costs.

3. MegaLo Mart provides the following information relating to its most recent year of operations.
MegaLo Mart charges off the entire cost of transportation in to the income statement for the
period.

Revenues $14,568,800
Beginning inventory, 245,600
1/1
Ending inventory, 260,400
12/31
Purchases 10,950,325
Transportation in 102,500
Sales commissions 437,064
Store rent 1,435,000
Store utilities 134,675
Other administration 879,345

Required:
Complete a GAAP income statement to determine MegaLo Mart’s profit before taxes.

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 Cost Flows and Cost Terminology

4. Consider the following expenses frequently incurred by manufacturing firms.

1. Connectors used to make a product
2. Labor to machine product components
3. Steel used to make components
4. Drill bits, saw blades, and other tools
5. Salary paid to the factory manager
6. Factory maintenance costs
7. Depreciation on materials-handling equipment
8. Holiday pay paid to assembly workers

Required:
Classify each expense as being direct materials, direct labor, variable manufacturing
overhead, or fixed manufacturing overhead. Please note that, for some of the eight
expenses, a portion of the cost could be in one category and another portion could be
in another category.

5. The following costs relate to a manufacturing organization:

Sales commissions Sales manager salary
Distribution costs Production supervisor
Factory rent Corporate office expenses
Product components Supplies used in manufacturing
Direct manufacturing labor Plant manager salary

Required:
Classify the costs as product costs or period costs. Also classify the costs as variable or fixed with
respect to the volume of production. What inferences do you draw about the correspondence
between the two concepts?

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Solutions to Exercises

1. (LO1) The following table provides the required classifications (with product costs listed first,
followed by period costs).

Salary paid to consultants Product cost. This is a cost of providing the service.
Travel to client site Product cost. This is a cost of providing the service.
Cost of general purpose software Product/period cost. This is an ambiguous item.
We can make a stronger case for product cost if it
pertains to a specific service. A general purpose
software like Microsoft Office probably would be a
period cost.
Fee for attending training seminar Period cost. This is part of the firm’s expenses for
maintaining skill, much like recruiting new
consultants.

Salary to office administrator Period cost. Pertains to administration.

Corporate office rent Period cost. Administrative support.

As this problem illustrates, we can classify many costs unambiguously as being product or period costs.
However, there is no bright line test. Some costs could be classified either way, with the specifics
determining the actual bucket.

2. (LO-2) The following is the GAAP margin statement for Boyd Associates.

Revenues $1,600,450
Cost of delivering service 1,150,450
Gross margin 450,000
Marketing & administration 174,600
Profit before taxes 275,400

We can readily obtain the answers by noting that revenue – cost of services = gross margin and
gross margin – marketing and administration costs = profit before taxes.

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 Cost Flows and Cost Terminology

3. (LO-3) The following is the GAAP income statement for MegaLo Mart. We learn that profit before
taxes for the year is $644,691.

MegaLo Mart
GAAP Income Statement
Item Amount
Revenues $14,568,800
Beginning inventory, 1/1 $245,600
Purchases 10,950,325
Ending inventory, 12/31 260,400 $10,935,525
Transportation in 102,500
Gross margin $3,530,775
Sales commissions 437,064
Store rent 1,435,000
Store utilities 134,675
Other administration 879,345
Profit before taxes $644,691

Notice that all costs related to getting the goods ready for sale go above the line for gross margin. All
period costs such as selling and administration expenses appear below the line.

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4. (LO-4) The following table provides the required classifications.

Item Classification Comments
Connectors used to Direct materials These items form a part of the product and
make a product vary with the volume of production.
Labor to machine Direct labor Some refer to this as “touch labor” because
product the workers physically touch the product.
components
Steel used to make Direct materials The steel becomes an integral part of the
components product and varies with the volume of
production.
Drill bits, saw Variable manufacturing These items are used to make many units
blades, and other overhead of the product and/or many products. We
tools would classify their cost as variable, as
making more units would require more
tools.
Salary paid to the Fixed manufacturing This item is a fixed cost; it is not directly
factory manager overhead traceable to units of any product.
Factory Partly fixed manufacturing Some items, such as the salary to the
maintenance costs overhead and partly maintenance manager, are fixed. Other
variable manufacturing items, such as the supplies used to
overhead maintain equipment, might vary with usage
and the number of units made.
Depreciation on Fixed manufacturing The amount does not vary with any obvious
materials handling overhead volume-related cost driver.
equipment

Holiday pay paid to Direct labor/ variable This item likely varies with labor cost. Some
assembly workers. manufacturing overhead firms include it as a part of direct labor.
Others treat the item as variable overhead,
allocating it by using labor hours or labor
cost as the allocation basis.

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 Cost Flows and Cost Terminology

5. (LO-4) The following table provides the required classification (with variable, product costs listed
first, followed by fixed, product costs, variable, period costs and fixed, period costs)

Item Product / Period Variable / Fixed

Product components Product Variable
Direct manufacturing labor Product Variable
Supplies used in manufacturing Product Variable
Production supervisor Product Fixed
Factory rent Product Fixed
Plant manager salary Product Fixed
Sales commissions Period Variable
Distribution costs Period Mixed (has both variable
& fixed portions)
Sales manager salary Period Fixed
Corporate office expenses Period Fixed

As the classification indicates, product/period costs correspond to business function. All

manufacturing costs are product costs while non-manufacturing costs are period costs. This
classification is useful for financial reporting. Product costs flow through the firm’s inventory
accounts. In contrast, we expense period costs during the accounting period.

Variability does not relate to function but is a cost characteristic. Thus, both manufacturing and
non-manufacturing costs could be variable or fixed.

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