CHAPTER 1: COSTS – CONCEPTS AND CLASSIFICATIONS

TOPICS
1. Definition of Cost
2. Classification of Costs
3. Costs for Planning, Control, and Analytical Processes

LEARNING OUTCOMES
1. Distinguish between cost, expenses, and losses.
2. Distinguish between direct and indirect costs.
3. Define the three integral components of a product.
4. Define prime costs and conversion costs.
5. Define variable, fixed, and mixed costs and discuss the effects o
volume on these costs.
6. Distinguish between common costs and joint costs.
7. Distinguish between capital expenditures and revenue expendi
8. Identify the costs for planning, control, and analytical processe

TOPIC 1: DEFINITION OF COST

Costs are associated with all types of organizations - business, non-business,

service, retail, and manufacturing. Generally, the kinds of costs that are incurred and the
way in which these costs are classified will depend on the type of organization involved.

Our initial focus will be on a manufacturing, but in our discussion, we should be

aware that, in a conceptual sense, manufacturing encompasses much more than just
firms in the industrial sector of our economy. It also encompasses many organizations
that are typically viewed as being service in nature, such as movie studios and fast-food
outlets. Organization such as these are involved in manufacturing in the sense that they
create a distinct product for customers or patrons. As we proceed with our discussion,
therefore, we should keep in mind that manufacturing is a broad term, and that the
costs included under the manufacturing heading have application to a wide range of
organizations - many of which may be involved in service-type activities. An
understanding of the costs structure of a manufacturing company therefor provides a
broad, general understanding of costing that can be very helpful in understanding the
costs structures of other types of organizations.

Before cost terminology can be discussed the term cost itself must be defined.
Cost is the cash or cash equivalent value sacrificed for goods and services that are
expected to bring a current or future benefit to the organization. We say cash
equivalent because non-cash assets can be exchanged for the desired goods or services.
For example, it may be possible to exchange land for some needed equipment.

Cost are incurred to produce future benefits in a profit-making firm, future

benefits usually mean revenue. As costs are used up in the production of revenues, they
are said to expire. Expired costs are called expenses. In each period, expenses are

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deducted from revenues in the income statement to determine the period’s profit. A
loss is a cost that expires without producing any revenue benefit. The focus of cost
accounting is a cost, not expenses.

TOPIC 2: CLASSIFICATION OF COSTS

A. COSTS CLASSIFIED AS TO RELATION TO A PRODUCT

A.1. MANUFACTURING COSTS/PRODUCT COSTS

Direct materials

All manufactured products are made from basic direct materials. The basic
material may be iron ore for steel, sheet for automobiles, or flour for bread. These
examples show the link between a basic raw material and a final product.

The way a company buys, stores, and uses materials is important. Timely
purchasing is important because if the company runs out of materials, the
manufacturing process will be forced to shut down. (Shutting down production results
in no products, unhappy customers and loss of sales and profits). Buying too many
direct materials, on the other hand, can lead to high storage costs.

Proper storage of material will avoid waste and spoilage. Large enough storage
space and orderly storage procedures are essential. Materials must be handled and
stored properly to guarantee their satisfactory use in production. Proper records, the
materials stockcars, make it possible to find goods easily. Such records reduce problems
caused by lost or misplaced items.

Direct materials are materials that become part of a finished product and can be
conveniently and economically traced to specific product units. The costs of these
materials are direct costs. In some cases, however, even though a material becomes
part of a finished product, the expense of actually tracing the cost of a specific material
is too great. Some examples of this include nails in furniture, bolts in automobiles, and
rivets in airplanes. These minor materials and other production supplies that cannot be
conveniently or economically traced to specific product are accounted for as indirect
materials. Indirect materials costs are part of factory overhead costs.

Direct labor

Labor services are, in essence, purchased from employees working in the factory.
In addition, other types of labor are purchased from people and organizations outside
the company. The labor costs usually associated with manufacturing include machine
operators; maintenance workers; managers and supervisors, support personnel; and
people who handle, inspect, and store materials. Because these people are all
connected in some way with the production process, their wages and salaries must be
accounted for as production costs and, finally, as costs of products. However, tracing
many of these costs directly to individual products is difficult.

To help overcome this problem, the wages of machine operators and other
workers involved in actually shaping the product are classified as direct labor costs.
Direct labor costs include all labor costs for specific work performed on products that
can be conveniently and economically traced to end products. Labor costs for
production related activities that cannot be conveniently and economically traced to

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end products are called indirect labor costs. These costs include the wages and salaries
of such workers as machine helpers, supervisors, and other support personnel. Like
indirect materials costs, indirect labor costs are accounted for as factory overhead costs.
Payroll related costs, such as payroll taxes, group insurance, sick pay vacation and
holiday pay, and other fringe benefits can be considered as part of direct labor costs but
are usually included as factory overhead.

Direct labor plus direct materials = prime costs, while direct labor plus factory
overhead = conversion costs. Prime costs and conversion costs may be diagrammed as
shown below.

Factory Overhead

The third manufacturing cost element is a catchall for manufacturing costs that
cannot be classified as direct materials or direct labor costs. Factory overhead costs are
a varied collection of production-related costs that cannot be practically or conveniently
traced directly to end products. This collection of costs is also called manufacturing
overhead, factory burden, and indirect manufacturing costs.

Examples of the major classification of factory overhead costs are Indirect

materials and supplies nails, rivets, lubricants, and small tools. Indirect labor costs loft-
truck driver’s wages, maintenance and inspection labor, engineering labor, machine
helpers, and supervisors.

Other indirect factory costs building maintenance, machinery and tool

maintenance, property taxes, property insurance, pension costs, depreciation on plant
and equipment, rent expense, and utility expense.

A.2 NON-MANUFACTURING COSTS/PERIOD COSTS

Marketing or selling expenses

Marketing or selling expenses include all costs necessary to secure customer

orders and get the finished product or service into the hands of the customer. Since
marketing expenses relate to contacting customers and providing for their needs, these
expenses are often referred to as order-getting and order-filling costs. Examples of
marketing expenses include advertising, shipping, sales travel; sales commissions, sales
salaries, and expenses associated with finished goods warehouses. All organizations
have marketing costs, regardless of whether the organizations are manufacturing,
merchandising, or service in nature.

Administrative or general expenses

Administrative expenses include all executive, organizational, and clerical

expenses that cannot logically be included under either production or marketing.
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Examples of such expenses include executive compensation, general accounting,
secretarial, public relations, and similar expenses having to do with the overall, general
administration of the organization as a whole. As with marketing expenses, all
organizations have administrative expenses.

B. COSTS CLASSIFIED AS TO VARIABILITY

Fixed, Variable, and mixed

One of the most important cost classifications involves the way a cost changes in
relation to changes in the activity of the organization. Activity refers to a measure of
the organization’s output of products or services. In specifying cost behavior, the
managerial accountant often limits the description to a specific range of activity. This is
called the relevant range.
Fixed cost

Items of cost which remain constant in total, irrespective of the volume of

production. Fixed cost is not related to activity within the relevant range. If activity
increases or decreases by 20 percent, total fixed cost remains the same: Cost per unit
decreases as volume increases, and increases as volume decreases. Fixed costs are
assignable to departments based on difference allocation methods. Examples are
salaries of production executives, depreciation of equipment computed on a straight-
line basis, periodic rent payments, and insurance.

Fixed costs may be classified into two categories, depending on the ability of
management to influence the levels of these costs in the short-term.

1. Committed fixed costs - costs that represent relatively long-term commitments on

the part of management as a result of a past decision.

Example - depreciation on equipment.

2. Managed fixed costs (also known as discretionary, programmed, or planned fixed

costs) - costs that are incurred on a short-term basis and can be more easily modified in
response to changes in management objectives.

Examples - advertising, research and development and costs of employee

training programs.

Shown on the next page is a graph of fixed cost. It is clearly shown that total
fixed cost remains unchanged as activity changes. When activity triples, from 10 to 30
units, total fixed cost remains constant at P 1,500. if activity level is only 1 unit, then the
fixed cost per unit is P 1,500. if the activity level is 10 units, then the fixed cost per unit
declines to P 150 per unit. So, we can conclude that fixed cost per unit will decrease as
we increase the volume or units of production and fixed cost per unit will increase as we
decrease the volume of production.

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Variable costs

Items of cost which vary directly, in total, in relation to volume of production. If

activity increases by 20 percent, total variable cost increases by 20 percent also. Cost
per unit remains constant as volume changes within a relevant range.

Examples are: direct materials, direct labor, royalties, and commission of

salesmen.

Shown below is a graph of total variable cost. As this graph shows total variable
cost increases proportionately with activity. When activity doubles from 10 to 20 units,
total variable cost doubles, from P 1,000 to P 2,000. However, the variable cost per unit
remains the same as activity changes. The variable cost associated with each unit of
activity is P100, whether it is the first unit, the fourth, or the tenth.

To summarize, as activity changes, total variable cost increases or decreases

proportionately with the activity change, but unit variable cost remains the same.

Mixed cost

Items of cost with fixed and variable components. Mixed costs vary with the
level of production, though not in direct relation to it, probably because part of the cost
is fixed while the rest is variable. Two types of mixed costs exist - semi-variable costs
and step costs.

1. Semi-variable cost. The fixed portion of a semi-variable cost usually represents a

minimum fee for making a particular item or service available. The variable portion is
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the cost charged for actually using the service. The cost of electricity where there is a
basic minimum charge plus a specified cost per kilowatt hour above the minimum is an
example of such a semi-variable cost. The cost charged for using a cell phone under a
plan is also an example of a semi-variable cost. The cost of the plan is fixed and it is for a
specified time used, however if the user exceeds the time allowed, then charge will be
made on a per minute basis.

Assume that a company rents a delivery truck at a flat rate of P 20,000 per
month plus P 1.50/km driven. The fixed portion is the P 20,000 monthly rental fees; the
variable portion is the P 1.50/km driven truck. If 10,000 km, are driven during the
month, the total monthly cost of the delivery truck is P35,000, computed as follows:

Flat fee (fixed portion) P 20,000

Variable portion - 10,000 km. X P 1.50 15,000
Total cost P 35,000

2. Step costs. The fixed part of step costs changes abruptly at various activity levels
because these costs are acquired in indivisible portions. A step cost is similar to a fixed
cost within a very small relevant range.

The superior’s salary is an example of step cost. Assume that one supervisor with
a salary of P 30,000 is needed for every 10 workers, then if 15 workers are used, 2
supervisors (with salaries of P 60,000) will be needed. If 18 workers are used, still 2
supervisors would be needed. If the number of workers increases to 22, three
supervisors would be needed.

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 Ideally, for both planning purposes and for making certain types of decisions, all
costs would be classified as either fixed or variable, with semi-variable costs being
separated into their fixed and variable components. One of the most important steps in
estimating the variable and fixed components of a mixed cost is to examine the cause
and effect relationship between activities that affect costs. There are different methods
of separating mixed costs into fixed and variable components: (1) scatter graph, (2)
high-low point, (3) and method of least square. We will illustrate the use of high-low
point method and method of least square.

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C. COSTS CLASSIFIED AS TO RELATION TO MANUFACTURING DEPARTMENTS

Direct departmental charges

Costs that are immediately charge to the particular manufacturing

department(s) that incurred the costs since the costs can be conveniently identified or
associated with the department(s) that benefited from said costs.

Indirect departmental charges

Costs that are originally charged to some other manufacturing department(s) or

account(s) but are later allocated or transferred to other department(s) that indirectly
benefited from said costs.

D. COSTS CLASSIFIED TO THEIR NATURE

Common cost

Costs of facilities or services employed in two or more accounting periods,

operations, commodities, or services. Just like indirect costs, these costs are subject to
allocation.

Joint cost

Cost of materials, labor, and overhead incurred in the manufacture of two or

more products at the same time/ A major difficulty inherent to joint costs is that they
are indivisible and they are not specifically identifiable with any of the products being
simultaneously produced. These costs are also subject to allocation.

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E. COSTS CLASSIFIED TO RELATION TO AN ACCOUNTING PERIOD

Capital expenditure

Expenditure intended to benefit more than one accounting periods and is

recorded as an asset. The allocation of the cost to the different periods is – depreciation
for fixed tangible assets, amortization for intangible assets and depletion for wasting
assets.

Revenue expenditure

Expenditure that will benefit current period only and is recorded as an expense.

TOPIC 3: COSTS FOR PLANNING CONTROL, AND ANALYTICAL

PROCESSES
Standard costs

Predetermined costs for direct materials, direct labor, and factory overhead.
They are established by using information accumulated from past experience and data
secured from research studies. In essence, a standard cost is a budget for the
production of one unit of product or service. It is the cost chosen by the managerial
accountant to serve as the benchmark in the budgetary control system.

Opportunity cost

The benefit given up when one alternative is chosen over another. Opportunity
costs are not usually recorded in the accounting system. However, opportunity costs
should be considered when evaluating alternatives for decision-making. If an asset can
be used to perform only one function and cannot be sold or used in other ways, the
opportunity cost of that asset is zero.

Example 1

Michelle has a part-time job that pays her P 1,000 per week. She would like to
spend a week in Bracey during summer vacation from school, but she has no vacation
time available. If she takes the trip anyway, the P 1,000 in lost wages will be an
opportunity cost of doing so.

Example 2

Marco is employed with a company that pays him a salary of P 20,000 a month.
He is thinking about leaving the company and returning to school. Since returning to
school would require that he give up his P 240,000 salaries, the forgone salary would be
an opportunity cost of seeking further education.

Differential cost

Cost that is present under one alternative but is absent in whole or in part under
another alternative. An increase in cost from one alternative to another is known as
incremental cost, while a decrease in cost is known as decremental cost. Differential
cost is a broader term, encompassing both cost increases (incremental cost) and cost

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decreases (decremental costs) between alternatives. The accountant’s differential cost
concept is basically the same as the economist’s marginal cost concept. In speaking of
changes in cost and revenue, the economist employs the terms marginal cost and
marginal revenue. The revenue that can be obtained from selling one or more unit of
product is called marginal revenue, and the cost involved in producing one more unit of
product is called marginal cost. Differential costs can be either fixed or variable. To
illustrate, assume that Avon Corp. Is thinking about changing its marketing method from
distribution through retailers to distribution by direct sale. Present costs and revenues
are compared to projected costs and revenues in the table below.

The differential revenue is P 300,000, and the differential costs total P 185,000,
leaving a positive differential net income of P 115,000 under the proposed marketing
plan. As noted earlier, those differential costs representing cost increases could have
been referred to more specifically as incremental costs, and those representing cost
decreases could have been referred to more specifically as decremental costs.

Relevant cost

A future cost that change across the alternatives. In the example above, the
relevant costs are cost of goods sold, advertising, commissions, and warehouse
depreciation.

Out-of-pocket cost

Cost that requires the payment of money (or other assets) as a result of their
incurrence.

Sunk cost

A cost for which an outlay has already been made and it cannot be changed by
present or future decision. Since sunk costs cannot be changed by any present or future
decision, they are not differential costs, and therefore they should be used in analyzing
future courses of action.
To illustrate the notion of a sunk cost, assume that a firm has just paid P 250,000
for a special purpose machine. Since the cost outlay has been made, the P 250,000
investment in the machine is a sunk cost. Even though the purchase may have been
unwise, no amount of regret can relieve the company of its decision, nor can any future
decision cause the cost to be avoided.

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