COST CONCEPTS & CLASSIFICATION

Cost is "a foregoing, measured in monetary terms, incurred or potentially to be incurred to

achieve a specific objective" (American Accounting Association).
Cost refers the monetary measure of the amount of resources given up or used for some
specified purpose. It is the value the goods or services expended to obtain current or future
benefits.
Costs can be classified in different ways. There are manufacturing costs and non-manufacturing
costs, direct and indirect costs, product and period costs, controllable and uncontrollable costs,
fixed and variable, etc.
Management accountants need to understand cost concepts because they are vital in many areas
of planning, control, and decision-making. In this unit, we will learn about the different types of
costs and product costing systems.

Types of Costs (Cost Classifications)

Costs can be classified into different categories for different purposes.
Costs may be categorized according to their:
(1) management function, (2) ease of traceability, (3) timing of charge against revenue, (4)
behavior in accordance with activity, and (5) relevance to decision making.

According to Management Function

1. Manufacturing costs - incurred in the factory to convert raw materials into finished goods. It
includes cost of raw materials used (direct materials), direct labor, and factory overhead.

2. Nonmanufacturing costs - not incurred in transforming materials to finished goods. These

include selling expenses (such as advertising costs, delivery expense, salaries and commission of
salesmen) and administrative expenses (such as salaries of executives and legal expenses).

According to Ease of Traceability

1. Direct costs - those that can be traced directly to a particular object of costing such as a
particular product, department, or branch. Examples include materials and direct labor. Some
operating expenses can also be classified as direct costs, such as advertising cost for a particular
product.
2. Indirect costs - those that cannot be traced to a particular object of costing. They are also
called common costs or joint costs. Indirect costs include factory overhead and operating costs
that benefit more than one product, department, or branch.
According to Timing of Charge against Revenue
1. Product costs - are inventoriable costs. They form part of inventory and are charged against
revenue, i.e. cost of sales, only when sold. All manufacturing costs (direct materials, direct labor,
and factory overhead) are product costs.
2. Period costs - are not inventoriable and are charged against revenue immediately. Period
costs include non-manufacturing costs, i.e. selling expenses and administrative expenses.

According to Behavior in Accordance with Activity

1. Variable costs - vary in total in proportion to changes in activity. Examples include direct
materials, direct labor, and sales commission based on sales.
2. Fixed costs - costs that remain constant regardless of the level of activity. Examples include
rent, insurance, and depreciation using the straight line method.
3. Mixed costs - costs that vary in total but not in proportion to changes in activity. It basically
includes a fixed cost potion plus additional variable costs. An example would be electricity
expense that consists of a fixed amount plus variable charges based on usage.

According to Relevance to Decision Making

1. Relevant cost - cost that will differ under alternative courses of action. In other words, these
costs refer to those that will affect a decision.
2. Standard cost - predetermined cost based on some reasonable basis such as past
experiences, budgeted amounts, industry standards, etc. The actual costs incurred are compared
to standard costs.
3. Opportunity cost - benefit forgone or given up when an alternative is chosen over the other/s.
Example: If a business chooses to use its building for production rather than rent it out to
tenants, the opportunity cost would be the rent income that would be earned had the business
chose to rent out.
4. Sunk costs - historical costs that will not make any difference in making a decision. Unlike
relevant costs, they do not have an impact on the matter at hand.
5. Controllable costs - refer to costs that can be influenced or controlled by the manager.
Segment managers should be evaluated based on costs that they can control.
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Manufacturing Costs and Non-manufacturing Costs
Costs, when categorized according to function, can be classified into: (1) manufacturing costs and
(2) non-manufacturing costs.

Manufacturing Costs
Manufacturing costs refer to those that are spent to transform materials into finished goods.
Manufacturing costs include direct materials, direct labor, and factory overhead.
Direct materials - cost of items that form an integral part of the finished product. They refer to
the major parts or ingredients. Examples include wood in furniture, steel in automobile, water in
bottled drink, fabric in shirt, etc.

Direct labor - cost of labor expended directly upon the materials to transform them into finished
goods. Direct labor refers to salaries and wages of employees who work to convert the raw
materials to finished goods.

Factory overhead - also called manufacturing overhead, refers to all costs other than direct
materials and direct labor spent in the production of finished goods. Factory overhead
includes indirect materials such as cost of nails, thread, glue, etc.; indirect labor such as salary of
the supervisor; and factory expenses such as rent of the factory space, depreciation of factory
equipment, utilities expense of the factory, factory supplies, etc.
Manufacturing costs are also known as factory costs or production costs.

Non-manufacturing Costs
Non-manufacturing costs refer to those incurred outside the factory or production department.
These are costs are not needed in transforming materials into finished goods. Non-
manufacturing costs include: selling expenses and general expenses.
Selling Expenses - also called Selling and Distribution Expenses. Examples include advertising
costs, salaries and commission of sales personnel, storage costs, shipping and delivery, and
customer service.
General Expenses - also called General and Administrative Expenses. Examples are: executive
salaries, salaries of administrative staff, accounting expenses, legal expenses, research and
development, and other costs related to general administration of the organization.

Example
Classify the following costs as either M: manufacturing (DM: direct materials, DL: direct labor,
FOH: factory overhead) or N: non-manufacturing (SE: selling expense, GE: general expense).
1. Factory supplies
2. Salary of production supervisor
3. Legal expense
4. Freight-out (delivery expense)
5. Marketing samples
6. Glue used in production
7. Wood in producing furniture
8. Salary of the company president
9. Advertising
10. Administrative office rent
11. Salary of factory workers
12. Depreciation of factory building
13. Depreciation of office equipment
14. Depreciation of display racks inside the store
15. Freight-in
Answers: (1) M-FOH; (2) M-FOH; (3) N-GE; (4) N-SE; (5) N-SE; (6) M-FOH; (7) M-DM; (8) N-GE; (9) N-SE; 
(10) N-GE; (11) M-DL; (12) M-FOH; (13) N-GE; (14) N-SE; (15) M-DM
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Direct Costs and Indirect Costs
Costs, when categorized according to traceability to the product or cost object, can be classified
into: (1) direct costs and (2) indirect costs.

Direct Costs
Direct costs are those that can be easily traced to or associated directly with a specific cost object.
A cost object is something for which cost is measured such as a specific product, a specific
department or a specific branch.
For example, ABC Company produces plastic food containers. The cost of plastic used in
production can be easily traced to the food containers. However, the cost spent for electricity is
not directly traceable to the food containers since such cost was not used solely for the
production of the product.
Examples of direct costs include direct materials, direct labor, and other costs incurred for a
particular product such as advertising and promotion costs for, say "Product A".
If the cost object is a department or a branch, all costs that can be associated directly to a
particular department or branch are direct costs. For example, salaries of sales personnel are
directly traceable to the selling department of the organization. Also, the salaries of the sales
personnel of "Branch A" can be traced directly to that branch.

Indirect Costs
Indirect costs are difficult to trace directly to a specific cost object. These costs are commonly
shared by multiple products, different departments, or branches; hence, such costs cannot
practically be traced to a cost object.
Examples of indirect costs include factory overhead costs, organization-wide advertising, taxes,
and other common or  joint costs.
Example
Classify the following costs as (D) direct costs or (ID) indirect costs in relation to a specific product.
1. Glue in book production
2. Income tax
3. Factory supplies
4. Wood in making furniture
5. Training and development
6. Machine maintenance
7. Leather in manufacturing shoes
8. Supervisor's salary
9. Depreciation of factory equipment
10. Direct labor
Answers: (1) ID; (2) ID; (3) ID; (4) D; (5) ID; (6) ID; (7) D; (8) ID; (9) ID; (10) D
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Product Costs and Period Costs
Costs, when categorized according to the timing of charge against revenue, can be classified into:
(1) product costs and (2) period costs.

Product Costs
Product costs refer to inventoriable costs. These costs are included as part of inventory and are
charged against revenues as cost of sales only when sold. In other words they are initially
classified as assets and are transferred to expense when they are sold.
All manufacturing expenses (i.e., direct materials, direct labor, and factory overhead) are product
costs. Direct materials, direct labor, and factory overhead are combined to form the products to
be sold, hence the term "product costs".
In the accounting records, the cost of finished products is accumulated in an inventory account -
usually "Finished Goods Inventory". When goods are sold, the cost is transferred from "Finished
Goods Inventory" in the balance sheet to "Cost of Sales" (or Cost of Goods Sold) in the income
statement.

Period Costs
Period costs are charged immediately against revenue. Unlike product costs, they are classified as
expenses right away. They are not included in inventory.
Period costs include selling and distribution expenses, and general and administrative expenses.
These costs are presented directly as deductions against revenues in the income statement.
Example
Classify the following costs as (PR) product costs or (PE) period costs.
1. Salaries of factory workers
2. Social security - factory workers
3. Travel expense- executives
4. Rework costs of defective products
5. Fringe benefits - administrative
6. Legal fees
7. Insurance on office building
8. Overtime - factory workers
9. Advertising expense
10. Leather in producing shoes
Answers: (1) PR; (2) PR; (3) PE; (4) PR; (5) PE; (6) PE; (7) PE; (8) PR; (9) PE; (10) PR
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Controllable Costs and Uncontrollable Costs
Costs, when categorized in relation to persons regulating them, can be classified into: (1)
controllable costs and (2) uncontrollable costs.

Controllable Costs
Controllable costs are costs that can be influenced or regulated by the manager or head
responsible for it.
For example: direct materials, direct labor, and certain factory overhead costs are controlled by
the production manager. Another example: the sales manager has control over the salary and
commission of sales personnel.

Uncontrollable Costs
From the term itself, uncontrollable costs are those that are not under the control of a specified
manager. These cannot be influenced by decisions or actions of the manager. These costs are
imposed by the top management or allocated to several departments. For example, a company-
wide advertising cost that is allocated by the central office to different departments is not under
the control of the department heads.
Other examples include depreciation, insurance, share in rent, share in organization-wide security
costs, etc.

Example
To effectively evaluate the performance of the production department of ABC Company, the
management accountant wants to determine the controllable and uncontrollable costs from the
following items:
1. Direct materials
2. Direct labor
3. Factory overhead and other charges
a. Indirect materials
b. Indirect labor (supervision)
c. Depreciation
d. Insurance
e. Allocated repairs and maintenance
f. Allocated rent and utilities expense
Answer: The controllable costs are: direct materials, direct labor, indirect materials, and indirect
labor (supervision). Depreciation, insurance, allocated repairs and maintenance, and allocated
rent and utilities expense are not under the influence of the production manager. Under
responsibility accounting, managers are evaluated based on costs that they can control. Hence,
uncontrollable costs are ignored in evaluating managers.
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Prime Costs and Conversion Costs
Manufacturing costs (direct materials, direct labor, and factory overhead) can be classified further
into: (1) prime costs and (2) conversion costs.

Prime Costs
Prime costs refer to the total cost of direct materials and direct labor.
Direct materials pertain to cost of items that form an integral or major part of the finished
product. Examples are steel in automobiles, rubber in tires, fabric in clothing, etc. Direct labor
refers to the salaries and wages of workers who transform the materials into finished goods.

Conversion Costs
Conversion costs refer to those that are spent to transform raw materials into finished goods, i.e.
direct labor and factory overhead.
Direct labor, as mentioned above, refers to the salaries of production workers. Factory overhead
refers to costs incurred in production other than direct materials and direct labor. Factory
overhead includes indirect materials (such as nails, staples, adhesives, etc.), indirect labor (such
supervisor's salary), and factory expenses (factory supplies, utilities, depreciation, and all other
expenses incurred in the factory).

Example 1
During the month of December, MGM Company used materials costing $360,000. Direct labor
cost amounted to $200,000 and factory overhead is estimated at $250,000 based on direct labor
hours. Compute for the prime costs and conversion costs.
Solution:
Prime costs = Direct materials + Direct labor
$360,000 + $200,000 = $560,000
Conversion costs = Direct labor + Factory overhead
$200,000 + 250,000 = $450,000
Example 2
ABC Company's prime costs amount to $650,000 while conversion costs amount to $600,000.
Total factory overhead is equal to $320,000. Compute for the cost of direct materials.
Solution:
Conversion costs = Direct labor + Factory overhead
$600,000 = Direct labor + $320,000
Direct labor = $280,000
Prime costs = Direct materials + Direct labor
$650,000 = Direct materials + $280,000 (from above)
Direct materials = $370,000
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Product Costing Systems
Manufacturing companies use either job order costing or process costing. The records may
reflect either actual values or estimated amounts based on standard costs and are adjusted later.
Let us take a look at the following cost accumulation systems:
1. Job order costing
2. Process costing
3. Hybrid costing
4. Standard costing
5. Backflush costing
6. Activity-based costing

Job Order Costing

Under job order costing, costs are accumulated per job. For example: Job 101, Job 102, Job 103,
etc. This product costing system is used by firms with limited quantities of products. This method
is used for unique or dissimilar products such as customized furniture, buildings, large boats,
custom dresses, and others.
Job order costing calculates the cost of a unit or set of units in a given order. An order is often
termed as "job", "batch", or "lot". The costs of materials, labor, and overhead of each job are
summarized in the job order cost sheet.

Process Costing
Under process costing, costs are not accumulated per job, batch, or lot. Instead, materials, labor,
and overhead costs are accumulated per production process or production department (cleaning,
mixing, assembly, packaging, etc.).
Process costing is commonly used by companies operating in mass production of similar or
identical products since the products go through the same processes. Job order costing, on the
other hand, is applicable to dissimilar or customized products.

Hybrid Costing
Some companies use job order costing and process costing at the same time. This is known as
hybrid costing. For example, a company might use job order costing for materials and process
costing for labor and factory overhead.

Standard Costing
Standard costing is used together with other cost accounting systems such as job order costing
and process costing. Under standard costing, estimated costs based on predetermined values are
used even if actual costs are not yet available. The estimated costs are adjusted later to reflect the
effect of actual costs incurred.

Backflush Costing
Backflush costing is most applicable to companies that use the just-in-time inventory system.
Under JIT, a company maintains no or low inventory. Inventories are sent by the supplier to the
company only at the exact time they are needed.
Under backflush costing, detailed tracking of the movement of costs is eliminated. Once
materials, labor and overhead are used, they are entered into finished goods (or a separate
control account first). Backflush costing simplifies the accounting process by eliminating the
details of work-in-process.

Activity-Based Costing
When computing for standard costs, the traditional system computes for a single overhead rate
using only one basis (usually direct labor hours or machine hours). For example, $500,000 factory
overhead cost over 100,000 direct labor hours results in $5 FOH per direct labor hour. If 150,000
labor hours are used, then the estimated factory overhead cost would be $750,000 (150,000
hours x $5).
However, under activity-based costing, several bases (known as cost drivers) are used. Costs are
accumulated per activity (ordering, processing, assembly, packaging, maintenance, etc.). The costs
are then allocated using different cost drivers such as number of orders, processing time,
machine hours, floor space, and others.
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