INTRODUCTION TO COST ACCOUNTING

Define Cost Accounting

Cost accounting is the process of tracking, recording and analyzing costs associated with the
products or activities of an organization. Cost accounting helps managers understand the costs
of running a business. It is concerned with cost accumulation for inventory valuation to meet the
requirements of external reporting and internal profit measurement. Modern cost accounting
originated during the Industrial Revolution, when the complexities of running a large scale
business led to the development of systems for recording and tracking costs to help business
owners and managers make decisions.

Cost accounting measures and reports financial and nonfinancial information relating to
the costs of acquiring or utilizing resources in an organization. It provides information for
both management accounting and financial accounting. That is the role of cost accounting: to help
management plan, make decisions, and control the organization.

Effective control depends on communicating information to management. By issuing performance

reports, the controller (who is regarded as the company's chief accountant) advises other
managers of activities requiring corrective action. These reports emphasize deviations from a
predetermined plan, following the principle of management by exception which is a concept
that dictates that managers should be provided with information that directs or focuses their
attention to activities that require corrective action

Cost accounting can also be defined as the systematic recording and analysis of the costs of
materials, labor and overhead incident to production. (http://www.merriamwebster.com/dictionary /cost
accounting)

Define Cost Management System

Cost management refers to the approaches and activities of managers in short-run and long-run
planning and control decisions that increase value for customers and lower costs of products and
services.

For example, rearranging the production-floor layout might reduce manufacturing costs, or
additional product design costs might be incurred in an effort to increase revenues and profits.

So a cost management system refers to a set of methods developed for planning and controlling
cost-generating activities to achieve profitability in the short run and maintaining a competitive
position in the long run. It helps to provide useful information which links plans and strategies to
actual organizational performance, thus benefiting all functional areas of the company.

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There are six (6) primary goals of a cost management system, namely:
1. to develop reasonable and accurate product or service costs;
2. to assess product/service life-cycle performance;
3. to improve understanding of processes and activities
4. to control costs;
5. to measure performance; and
6. to allow the pursuit of organizational strategies.

A cost can be controlled only when the related activity is monitored and the information is
available. For example if spoilage occurs in a production process, the cost management system
should provide information on spoilage quantity and cost so that managers can determine the
underlying causes of spoilage. Information generated from a cost management system will also
help managers to measure and evaluate human or equipment performance as well as future
investment opportunities.

Relationship with Financial Accounting and Management Accounting

Cost Accounting is a bridge between Financial and Management Accounting. It serves the ever-
changing needs of management. Cost Accounting integrates with Financial Accounting by
providing product costing information for financial statements and with Management Accounting
by providing some of the quantitative, cost-based information which supports management
information needs as illustrated in Exhibit 1.

Unlike Financial Accounting where GAAP determines what must be reported and how it is
reported, the guiding light for Cost Accounting is usefulness

Cost accounting data are accumulated via a cost accounting system and allocated to various cost
objects to facilitate wise decision making. Those that do not manufacture products may not require
elaborate cost accounting systems. Even service firms need to understand how much their
services would cost so that they can determine whether it is cost-effective to engage in those
particular business activities.

Financial Accounting is designed to meet external information needs and to comply with
GAAP. Management Accounting serves to satisfy internal information needs and to provide
product costing information for financial statement reporting purposes.

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 Management Financial
Accounting Accounting

Cost Accounting

Exhibit 1.1
Relationship between: Cost, Management, & Financial Accounting

Exhibit 1.1 shows the interrelationship between the three accounting fields. Cost accounting plays
as the foundation of financial and management accounting. One cannot prepare financial
statements nor internal management reports i.e. budgets, pricing reports, etc without first
determining accurately as possible the cost of the product the company is producing.

The Cost Department

The cost department keeps detailed records of materials, labor, factory overhead, and marketing
and administrative expenses; analyzes these costs; issues control reports; prepares cost studies
for planning and decision making; and coordinates cost and budget data with other departments.

For product research and design, the manufacturing departments need estimates of materials,
labor, and machine process costs; for measuring and efficiency of scheduling, producing, and
inspecting products, the departments need to know the costs incurred. The personnel department
supplies employees' wage rates. The treasury department needs accounting, budgeting, and
related reports in scheduling cash requirements. The marketing department needs cost
information in setting prices. The public relations department needs information on prices, wages,
profits, and dividends in order to inform the public. The legal department needs cost information
for keeping many affairs of the company in conformity with the law. (Cost Accounting by Carter,
14th edition)

The Cost Department is a department responsible for gathering, compiling and communicating
information about the company's activities. It analyzes costs and and reports tailored fit to the
needs of company's management for use in controlling and improving operations. It coordinates
with the other departments such as the Production Department, Personnel or Human Resources
Department, Treasury Department, Marketing Department, Public Relations Department and
Legal Department. It is headed by the company's cost accountant with the latter under the
supervision of the general accountant or the company's comptroller.

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Organizational Hierarchy

All positions or functional units can be categorized in most organization charts into two (2) groups:
the line position which makes decisions and the staff position which gives advice and performs
technical functions.

Within the organization, one needs to know what is his responsibility and to whom he is
accountable to in order to delineate superior-subordinate relationship. Accountability is identical
with responsibility accounting. Accountability deals with the discharge of an individual's
responsibility to achieve assigned objectives within the costs and expenses allowed for the
performance and agreed to by the individual.

CFO/ VP
Finance

Comptroller/
Treasurer
Controller

Cost
Cashier
Accountant

Accounting Payroll
Staff Clerk

Exhibit 1.2
Hierarchy of responsibility & accountability in the Cost Department

Exhibit 1.2 shows the usual hierarchy within the organization. Generally, the Finance/Accounting
Department in an organization is headed by the Chief Financial Officer (CFO) or the Vice
President for Finance as in some other institutions. The controller (otherwise known as
comptroller) is the one who supervises the cost accountant in the accounting department, whose
function is classified primarily as a staff function. Organization charts are used by companies to
present the line and staff functions. It is useful to ascertain the superior who supervises and
oversees the staff function and to whom a staff is accountable.

The controller and the treasurer within an organization has different functions as the former is
primarily responsible for the cost accumulation and preparation of cost reports while the latter
oversees the coffers of the company. The treasurer is responsible in handling the inflow and
outflow of cash in an institution.

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The Role of Cost Accountant

Accounting is a staff function as it provides advice to those in the line position. To be an important
player on the management team, a controller needs the skills required of all high level executives
excellent written and oral communication skills, competent accounting skills, solid interpersonal
skills and a deep knowledge of the industry in which the firm competes. Such qualifications may
also apply to the Cost Accountant who keeps records of the costs of production and distribution
of the company's products or services.

The company's cost accountant is tasked to provide various types of information for external
financial reports such as inventory valuation, which in turn impacts cost of goods sold. He may
also be involved in the compilation or updating of the notes to financial statements. He also
produces reports for internal use which are not governed by the application of GAAP as the cost
accountant is free to use any costing paradigm that will result in the most informative reports for
the management team. The format and content of internal reports may vary substantially from the
format used for external reporting. Such internal reports may include any of the following:

Corporate-level reports. These reports may include relevant information about a few
critical success factors that would be most interesting to senior managers in influencing bottom-
line profits and return on assets for each production facility or store, and do forecasting at the
product line level. The format used may vary not only by company but also over time within each
company as different reporting items become less or more important to the senior management
team. There is no reason at all to include very detailed reports to senior managers as they do not
have the luxury of time reading it page by page.

Business unit-level reports. These reports must include a larger quantity of information
for the plant manager to know about the operation of each department, as well as a host of
operational issues such as machine utilization, cost of quality, inventory turnover, profitability, and
cash flow projections. This tends to be the most voluminous report which includes the greatest
mix of financial and operational information.

Function-level reports. These reports can be issued to individual departments or at lower

levels like the supervisors of individual machines. Such reports are custom-designed for each
recipient, with some requiring more financial data (e.g., for the sales manager who wants to know
about the number of customer orders booked) and others including almost entirely operational
information (e.g., for the warehouse manager who is interested in inventory turnover).

Project-specific reports. A project report focuses on those costs being incurred for a
specific purpose and so tends to be heavy on direct costs. This report usually compares actual
costs against budgeted costs expected to have been incurred at various stages of the project. If
a project is already bringing in revenues, the reporting structure can be converted to a profit center
format. This format tends to have few operational statistics besides percentage of completion and
lists of to-do items that must be finished in order to ensure conclusion of the project.

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 Decision-specific reports. Many times the cost accountant is called on to report about a
specific issue that occurs only once, after which the report is discarded. For example, a report
may be needed that describes the particular quality costs associated with the selection of three
prospective production processes the management team is considering installing. Once the
decision is made and the installation is complete, there is no need for the report. Another example
is a review of waste in a production process-the report may cover such information as times
elapsed when moving products between work stations, setup times, cycle times, and the space
occupied by idle work in process. This report is less concerned with financial issues than with
process efficiency but it is still the cost accountant's job to complete it. Clearly, these reports can
cover virtually any topic and can include any type of information: may it be financial, operational,
or a mix of both.

An enormous range of topics can be covered by internal reports. Because they lack the amount
of structure imposed on external reports, they are much more interesting to prepare, giving the
cost accountant free rein to design the perfect format that will result in easy readability and
effective management decision making.

Cost accountants are in the best position to supply the budget information since they have
access to all the needed information-bills of material, routings, throughput capacity constraints,
and sales estimates by unit. Similarly, the direct labor budget requires input about expected labor
costs, which requires information from the cost accountant regarding expected labor utilization
rates and overtime estimates.

If there is no Human Resource Department to provide information about labor and benefit
costs, the cost accountant is expected to supply this information too. It may also be necessary to
assist in compiling estimated costs for various departments that do not have an internal staff
skilled in such work and help them determine cost estimates for the coming budget period.

Finally, the cost accountant is frequently called on to estimate facility-wide budgeted costs,
including repairs and maintenance, insurance, and utilities. Given the wide-ranging nature of
these costs, it is evident that the cost accountant can expect to allocate a great deal of time to the
budgeting activity at the times of the year that it is done. Product costing information is essential
in determining appropriate prices. The cost accountant is in charge of compiling these costs and
presenting them to the sales or marketing staff. This is true for special orders when valued
customers offer a large volume of product only if the sales price is substantially lowered. In this
case, the cost accountant must determine the direct cost of the special order as well as the
incremental costs associated with the production run that creates the customer's product. It may
also be useful to determine the overall impact on the company's profits via a throughput
accounting analysis. A separate analysis must be made for each customer pricing request since
larger companies may face these issues on a regular basis, they may employ teams of cost
accountants who deal with only this type of work.

Another important pricing-related task is determining the profitability of individual customers,

products, product lines, or facilities. Each of these calculations must incorporate only the costs

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relevant to the particular analysis. For example, a review of profits by customer may include only
direct costs if the analysis is meant to cover a short period of time, but should use activity-based
costing (ABC) if the company's long-term impact on profits is the objective of the analysis. For
short-term analysis profit impact using throughput accounting should be included. Given the wide
range of costing method available, these analyses can take a great deal of time and require
extensive explanation for the management team so that they fully understand the consequences
of any action taken based on this information.

The cost accountant has a great deal of influence over the types of data collection and
summarization systems used by a company as well as those that one would not normally
associate with the cost accounting function.

A main concern of the cost accountant is collecting a large enough quantity of data to create a
sufficiently large pool of information that can be used for various types of costing analysis.
However, there is a cost associated with the collection of data, so higher costs are incurred in
collecting more data. Consequently, the cost accountant must spend time exploring new types of
data collection automation to keep these costs low, while still providing sufficient quantities of
data. For example, replacing manual time cards for direct labor personnel with automated bar
code scanning equipment eliminates a significant amount of the labor costs associated with it.

It is also common to be involved in the assignment of costs to various entities, such as

departments or product lines and to constantly re-review this information and reassign the costs
as needed. This is a common activity in organizations where managerial compensation is based
on localized profits, since managers are constantly attempting to shift cost allocations away from
their areas of responsibility, thereby producing instant improvements in the profits attributed to
them. Rather than allocating costs, as just noted, the cost accountant may be asked to take the
reverse approach, that is, to determine why costs have been incurred and allocated in a
certain manner by tracing them back through the accounting system, perhaps all the way
back to their original source documents. This information can be used for a simple report to
management regarding the causes of costs, or it can be used as the foundation for a project to
alter the system to allocate costs in a different manner.

It is also common to be assigned to any number of cost-related projects as an internal consultant.

For example, a department manager may want to know what will happen to costs if certain
functions are outsourced to a supplier. Alternatively, the warehouse staff may want assistance in
determining the amount by which working capital requirements will be reduced if a new project to
shrink inventory levels is implemented.

In addition, it may be necessary to conduct a benchmarking study to find better ways to

complete a task, either by searching within other divisions of the company or looking outside the
company for "best practices". These activities may stop with a presentation of the suggested
improvements to management but can continue through monitoring of the implementation of
these best practices-a common activity for the cost accountant. Thus, the cost accountant may
be asked to review a wide variety of function-specific activities on a project basis.

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The cost accountant may also be required to assist in preparing legal justification for the
company's case and may even be called on to testify. He can contribute several types of
costing information to the planning process that are of assistance in making strategy alterations
that will result in enhanced profitability levels or at least in the avoidance of low-profit strategy
alternatives. A large part of this information comes from a database of costs that encompass a
much wider range of potential production volumes than those currently used by the company.
With this information, strategy planners can determine what will happen to internal costs if the
company pursues various strategies that either increase or decrease production or sales volume
for various product lines.

Another contribution to corporate strategy is the use of throughput accounting. This method allows
the corporate planning staff to determine which equipment is currently causing the primary
production bottleneck. It can use this information to shift the bottleneck to a different point in the
production process if it will result in changes in the mix or in the volume of products manufactured
that will cause a significant profit alteration. One can also use this information to create a plan for
producing a specific set of products that will make the most effective use of the existing bottleneck.
This allows a company to redirect all its sales and marketing, production, and materials
management activities around the sale and manufacture of the highly profitable products.

The cost accountant can reliably expect to be assigned various tasks and that what make his job
an interesting one, far more than that of a general accountant, whose job is much more closely
defined by external accounting reporting rules. The cost accountant’s recommendations
ultimately have a direct impact on the company's operations and over profitability.

Two (2) Basic Stages of Accounting for Costs

A cost system accounts for costs in two (2) basic stages. The first stage is cost accumulation, the
collection of cost data in an organized way by means of an accounting system. The second stage
is cost assignment, a general term that embraces both tracing and cost allocation. Cost tracing
refers to the assignment of direct costs to particular cost object while Cost allocation refers to
the assignment of indirect on to a particular cost object. In other words, it is the assigning of a
common cost to several cost objects.

Concept of a Cost Object

Cost Accounting involves the calculation of the cost of something, that something is called cost
object. A cost object refers to any unit, activity or segment for which management wants to
accumulate and measure a cost. That unit or activity may be a product or service unit, contract,
project, process, depot, department or business segment or other subdivision of a company.

In cost assignment, you have to know whether costs have a direct or indirect relationship to a
particular cost object. Several factors affect the classification of cost as direct or indirect such as
materiality (or relative importance) of cost, information-gathering technology available, and design

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of operations. Consider this question: Is a production department manager's salary a direct cost
or an indirect cost? The answer: It depends on the choice of the cost object.

For example, if the cost object is the production department, the salary is a direct cost because it
can be traced to the cost object. But if the cost object is one of the many products manufactured
in the production department, the salary is an indirect cost because it can be allocated (as it
cannot be traced) to the cost object.

Costs vs. Expenses

Many people use these terms interchangeably. Accountants define cost, as a resource sacrificed
(used) or forgone to achieve a specific objective. Hence, a cost is the amount of resources given
up in order to receive some goods or services and represents future economic benefit to a
company. For example, it might cost P5, 000 per month to rent retail space in a shopping mall.
To guide the manager's decision, he often wants to know how much a particular thing costs. This
"thing" is called cost object, anything for which is are measured and assigned or it answers the
question "What is to be costed?".

An asset is a cost. As costs are used up in the production of revenues, they are said to
expire and these expired costs are called expenses. Expenses are matched with revenue on the
income statement. A good example for understanding a cost and expense is a fixed asset. When
a fixed asset is purchased, it is a cost to the company and is shown on the statement of financial
position. When the fixed asset is used, it is depreciated and a portion of the cost becomes a
depreciation expense, which is included in the income statement and matched with the revenues.

The unexpired cost shall be recognized as an asset though ultimately it will become an
expense by the passage of time or as the cost has expired as it is used up by the business to
earn revenues. Expenses and losses are both considered as expired costs. However the
distinction is that expenses are intentionally incurred in the process of generating revenues while
losses are not intentionally incurred.

Cost Classification

Classification of cost means the grouping of costs according to their common characteristics.
Sometimes cost classification requires an accountant to exercise his good judgment. By
understanding the different cost terminologies, you will be able to classify costs according to:

I. Time period for which the cost is computed:

 Historical Costs are costs incurred in the past. This is the type of cost used primarily in the
preparation of financial statements for external reporting purposes.

 Budgeted Costs are costs expected to be incurred in the future.

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II. Management Function

 MANUFACTURING COSTS (also known as production costs or factory costs) are those
costs associated with the production activities of the company. The three (3) cost elements
of production are Materials, Labor and Factory Overhead

Materials Costs

 Direct Materials are those materials that form an integral part of the finished product
whose costs can be conveniently traced into it. The following are included as part of
direct material costs:
o invoice price less discounts (whether taken or not)
o sales taxes
o customs duties
o delivery costs paid to vendors
o cost of delivery containers, net of deposit refunds

 Indirect Materials are those materials needed to complete a product but the use of which
is so minimal or so complex that treating them as direct materials is futile. Such items of
material may become an integral part of the finished product but may be traceable into
the product only at great cost and inconvenience Glues, nails, welding materials, grease,
lubricating oil, cleaning rags, brushes and other minor items are called indirect materials
(or supplies) and are classified as part of factory overhead.

Labor Cost

 Direct Labor is the labor directly involved in making the product or those labor costs that
can be so traced without undue cost or inconvenience The following are included as
elements of direct labor cost:
o basic compensation
o production efficiency bonuses
o employer's portion of social security taxes
o cost of living allowance (COLA)

 Indirect Labor is defined as expended labor which does not directly affect the
construction or the composition of the finished product or those factory labor costs which
are supportive or supervisory in nature whose services are essential to factory operations
but do not work directly on the product. This includes the wages of supervisory personnel
and janitors which are classified as part of factory overhead. These are incurred to
support production.

Note that premium pay for overtime, special shifts, or for work on holidays is usually
treated as indirect labor and included as manufacturing overhead unless such work
relates to the requirements of a specific product.

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 Factory Overhead (also known as manufacturing overhead; production overhead; factory
expense or factory burden) are those production costs incurred in the plant or factory that
cannot be classified as direct materials nor direct labor. This includes factory supplies or
indirect materials used, indirect labor, depreciation of plant assets, fringe benefits, payroll
taxes and cost of idle time.

Prime Cost is the sum of direct materials and direct labor costs.

Conversion Cost is the cost of converting direct materials into finished product and is the sum
of direct labor costs and factory overhead.

DIRECT MATERIAL
COST
PRIME COST

DIRECT LABOR
COST
CONVERSION
COST
FACTORY
OVERHEAD COST

 NON-MANUFACTURING OR NON-PRODUCTION COSTS are the costs associated with the

functions of selling and administration.

 Selling (marketing or distribution) expenses are the expenses associated with obtaining
sales and the delivery of the product or service. Fixed marketing expenses are also
identified as CAPACITY COSTS while variable marketing costs are referred to as
VOLUME COSTS. Since marketing costs relate to contacting customers and providing for
their needs, these costs are often referred to as order-getting and order-filling costs.

 General and Administrative Expenses include those expenses incurred in connection with
performing general and administrative activities. It includes all executive, organizational
and clerical costs that cannot logically be included under production nor marketing.

 Cost of Goods Manufactured represents the total cost of goods completed during the current
period.

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III. Generally Accepted Accounting Treatment

 Product Cost or inventoriable cost is any cost incurred in the factory. Product costs are
inventoried if not sold & are expensed only when revenue is recognized.

 Period Costs are costs that are expensed in the period in which they are incurred. A period
cost is identified with a time period & not with the production of products & services. The
time period in which the benefit is received is the period in which the cost should be
deducted as an expense.

IV. Their Ease of Traceability

Costs may be viewed as either direct or indirect in terms of the extent that they are traceable to a
particular costing object such as products, jobs, departments, and sales territories. A direct cost
in one situation may be an indirect cost in another.

For example, the salary of a production department supervisor is a DC of the plant & that
department, but it is an indirect cost with respect to an array of products produced in that
department.

 Direct Costs are those costs that can be directly traceable to a costing object. Examples
are direct materials, direct labor, and advertising outlays made directly to a particular sales
territory.

 Indirect Costs are costs that are difficult to directly trace to a specific costing object, i.e.
factory overhead and those costs shared by different departments or segments called
common costs or joint costs.

 Avoidable Costs are costs that will not be incurred if an activity is suspended or stopped.
They are the cost savings arising from a decision to discontinue an undertaking or it is a
cost that can be eliminated (in whole or in part) as a result of choosing one alternative
over another.

V. Behavior or in relation to Volume or Activity Level (The way a cost responds to a change in
activity is known as its cost behavior)

 Fixed Costs are costs that remain constant in total but will vary on a per unit basis within
the defined relevant range regardless of changes in activity level.

 Variable Costs are costs that vary in total as the volume of production or sales changes.

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 TOTAL COST PER UNIT COST
VARIABLE COSTS Changes in direct proportion Remains constant regardless
to the change in activity level of change in activity level

FIXED COSTS Remains constant regardless Changes in inverse proportion

of change in activity level to the change in activity level

Exhibit 1.3 Distinction between variable cost & fixed costs within the relevant range

 Mixed Cost or Semi-Variable Costs are costs that vary with changes in volume but unlike
variable costs, do not vary in direct proportion. Semi-variable costs tend to be
predominately variable but with a change in per unit cost as activity changes.

Examples are the rental of a delivery truck where a fixed rental fee plus a variable charge
based on mileage is made; and power costs where it consists of a fixed amount plus a
variable charge based on consumption which is also true to most of the utility costs.

This type of costs' behavior is difficult to classify as to whether it is variable or fixed for
internal reporting purposes. It is likewise necessary to estimate its fixed or variable portion
through the use of various methods such as high & low points method, scattergraph
method or the least squares method.

 A step cost is a variable or fixed cost that shifts upward or downward when activity
changes by a certain interval or step. It is a cost that increases by a fixed amount as
certain levels of activity are reached. Step costs may have a few large steps & be fixed
over broad ranges of activity or have many small steps & appear to act like variable costs.

 Semi-fixed cost is a cost that increases in lumps of cost with changes in output or activity.
Semi-fixed costs are predominately fixed but change in peso lumps at some point within
the relevant range.

For cost behavior information to be properly identified, analyzed, and used, a time frame must be
specified to indicate how far into the future a cost should be examined, and a particular range of
activities must be assumed. The assumed activity range usually reflects the company's normal
operating range and is referred to as the relevant range.

When fixed costs are involved, the average cost of a unit of product will depend on the # of units
being manufactured. As production increases, the average cost per unit will fall as the FC is
spread over more units. Conversely, as production declines, the average cost per unit will rise as
the FC is spread over fewer units.

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 Step-variable costs are costs that stay fixed over a range of activity and then change after this
range is overcome. In other words, these costs change in increments.

Step-variable costs include characteristic of both variable and fixed costs in a way that (a) such
costs change as production level changes, and (0) such costs change only when a production
level (range of activity) is overcome. Within that range of activity, step variable costs remain fixed.

The major differences between step-variable costs and fixed costs are that step variable costs
are changed by activity (rather than by a management decision) and they are more easily changed
compared to fixed costs

To illustrate step variable costs, assume that an employee can operate one equipment to produce
100 valves per day. If 320 valves need to be produced, the company would hire four employees
(three employees won't be enough because three employees can only produce 300 valves), If the
valve production requirement is increased to 400 units, four workers will still be able to cope with
the work load. However, for 410 valves, an additional, fifth employee would be needed

Thus, the company's payroll costs change in steps, from costs for four (4) employees at 320 or
units, to payroll costs for five (5) employees at 410 units.

Step-variable cost graph

Exhibit 1.4
Step-Variable Cost

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This graph describes step-variable payroll costs, where the width of each step represents the
volume of activity (i. e valve production) needed before the step-variable costs increase to the
next level (i.e. an additional employee is hired). Once the next level is achieved, the payroll costs
increase and remain constant until the next level is achieved again.

Note that a narrow width means that a step-variable cost is sensitive to fairly small fluctuation in
related activity. Other examples of step-variable costs and their cost drivers are provided below.

Examples of step-variable costs

Type of Business Cost Cost Driver

Manufacturing Number of workers Number of units produced

Restaurant Number of waiters Number of clients

Hotel Number of housekeepers Number of rooms occupied

Hospital Number of nurses Number of patients

VI. Significance in Decision Making

 Relevant Costs (also known as differential costs are expected future costs that will differ
between 2 or more alternatives. Such costs may either be incremental decremental.
Incremental costs are the cost increases or the additional costs while decremental costs
are the decreases in cost.

 Irrelevant Costs are costs that do not relate to any of the decision alternatives and are
either historical in nature, or are the same under all decision alternatives.

VII. Managerial Control or Managerial Influence

 A cost is said to be controllable when the amount of the cost is assigned to the department
head and the level of the cost is significantly under the manager's influence.

 Non-controllable costs are those not subject to influence at any given level of managerial
supervision or influence.

VIII. Commitment to Cost Expenditures

 Out-of-Pocket Costs are costs that must be met with a current expenditure or cash outlay.
It is opposite to imputed costs.

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  Committed Costs are costs that are the inevitable consequence of a previous commitment.
It is a cost item that cannot be changed the short-run as it results from a commitment
made in the past like depreciation of equipment

 Discretionary Costs or Programmed Costs (subject to managerial control) are costs for
which the size or the time of incurrence is a matter of choice. It is an item of cost which
can be changed by management decisions like advertising expense.

 Marginal Costs are costs associated with the next unit or an incremental cost associated
with additional unit produced or sold.

 Sunk Costs are the cost of resources already incurred in the past whose total will not be
affected by any decision made now or in the future. These are the past costs about which
nothing can be done hence they are considered as irrelevant costs.

 Imputed Costs are hypothetical costs representing the cost or value of a resource
measured by its use value. They do not involve actual cash outlay, not recorded in the
books and not considered in the company’s regular cost and profit calculations. Examples
are the interest on invested capital and the rental value of company-owned properties.

IX. Other Cost Classification

 Standard Cost is production or operating cost that is carefully predetermined. It is a target

cost that should be achieved.

 Opportunity Cost is the net revenue foregone by rejecting an alternative, or the

measurable value of an opportunity bypassed by rejecting an alternative use of resources.
It is a type of future costs.

 Information Costs are the costs of obtaining information.

 Ordering Costs are costs that increase with the number of orders placed for inventory like
preparing the requisition and the purchase order, handling the incoming shipment,
preparing a receiving report and communicating in case of errors or delays in receipt of
materials.

 Capitalized Costs are treated as assets and become expenses in future periods as the
asset is depreciated or amortized.

 Engineered Cost is an item of cost for which the optimum amount that should be spent
can be estimated. It has a clear relationship to output. Examples: Direct materials and
direct labor costs.

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  Postponable Costs are costs that cannot be avoided but the incurrence of which is
deferred at a future date.

 Staff Service Costs are incurred by the different departments that provide assistance to
the line or operating units. They are indirect costs of the line departments with the
exception of those costs which are traceable directly to the latter.

 General Corporate Costs are those incurred in the general management of a company
and in meeting the company’s public responsibilities. They are seldom identified with a
specific function so that they are treated as indirect costs in general. Examples are the
compensation given to the members of the BOD, top executives, and their personal staffs,
donations to charitable organizations, membership fees in trade associations, costs of
court litigations, and the costs of the legal staff.

 Costs of Capital are the costs of using the capital invested in the assets of the company.
It consists of both the costs of borrowed capital and costs of equity capital.

 Distribution Costs refers to the costs directly related to the marketing of a company’s
products as storage costs, advertising, commissions, salesmen’s salaries and shipping
costs. It refers to all expenditures made from the time the finished product leaves the
factory unit it is delivered to the customer and the customer’s payment has been recorded.

 Order-getting costs are the costs incurred to increase the volume of sales or to obtain the
desired sales mix. They are incurred to improve the sales level and are not generally
traceable to sales orders.

 Order-filling (or logistics) costs are those costs incurred to enable the company to fill an
order or deliver the product to the customer. They are incurred based on actual sales
orders and/or expected sales volume so that most of them can be traced to sales orders.
They will include warehousing or storage costs, packing & shipping costs, order-assembly
costs, transportation costs, credit & collection costs and also financial costs of carrying
inventory.

Classes of Inventories in a Manufacturing Firm and their Stages of Production

In a manufacturing firm, the production or conversion process can be viewed into three (3) stages:
1) work not started; 2) work started but not completed yet; and 3) fully completed work. Cost of
inventories associated with each stage include raw materials inventory, work in process inventory
and finished goods inventory,

Perpetual inventory system is used to account for these three (3) classes of inventory of a
manufacturer. The controlling accounts used and the related subsidiary records are as follows:

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 Controlling Accounts Subsidiary Records
Materials Material ledger card
Used for both direct and indirect materials

Work in process Inventory Job Order Cost Sheet

Represents the accumulated cost of (for job order costing) Cost of
unfinished units or jobs still in process Production Report

Cost of Production Report

(for process costing)

Finished Goods Inventory Finished goods ledger card

Represents the accumulated cost of the
finished units of the completed jobs

Costing for a Service Provider or Service Companies

In a service firm or service providers, the work not started stage consists of the cost of supplies
needed to perform the services which is reflected in the account called Supplies or Supplies
Inventory. When the cost of supplies are charged to a particular customer or job order, conversion
costs are also added to determine the total cost of services provided which shall be used as the
basis in determining the amount to be billed to that customer after the markup has been added.
Determining the cost of services provided is essential for both profit-oriented service businesses
and not for profit entities. For example, architectural firms accumulate the costs incurred for
designs and models of each project while hospitals accumulate the costs of an X-ray, MRI or
Outpatient Services for each patient.

Like product costs, cost of services includes three (3) components: Direct Materials, Direct Labor
& Overhead. However, the proportions of each may vary since service firms typically have few
material costs and large amounts of labor & overhead. Although they have both direct & indirect
costs, they generally have larger proportions of indirect costs. So the predetermined overhead
rate is typically based on direct labor cost. It is also common to combine labor cost with the
predetermined overhead rate, so the amount charged to a job for each direct labor hour
represents both labor and overhead. The only remaining items to be charged to each job are the
directly traceable costs other than labor. In a repair shop, cost of parts corresponds to direct
material cost in manufacturing. In a professional service business, directly traceable costs include
costs of travel, meals, entertainment, long distance telephone charges, photocopying &
subcontracted services. Work in process accounts are commonly used on projects that were
incomplete at month-end, such as audits by accounting firms, lengthy legal cases by law firms,
and consulting engagements that are long term.

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An employee who incurs reimbursable expenses is typically required to report the date of the
expenditure, the client's name or job #, the nature of the cost, & an original receipt for large
amounts. This information establishes the legitimacy of the reimbursement & also enables the
costs to be traced directly to jobs. To trace long distance telephone charges, each employee is
required to log each call. Weekly or monthly summaries of all costs are prepared and entered on
the job order cost sheet.

Cost of Goods Sold Statement

A company must determine first how much of the available supply of materials (both direct and
indirect) was transferred into production during the period. The perpetual inventory system tracks
the material as it is placed into production. Shown below is a pro-forma schedule of direct
materials used which summarizes the activity for the period and concludes with the peso amount
attributed to direct materials that have flowed into the production cycle:

Schedule of Direct Materials Used

Materials Inventory Beginning………………………………………………………… P xx

Add Net Purchases of Materials……………………………………………………… xx
Materials Available for Use…………………………………………………………… P xx
Less Materials Inventory End………………………………………………………… Xx
Direct Materials Used or Raw Materials Transferred to Work in Process Pxx

This raw material transferred to production appears in the schedule of work in process follow.

Schedule of Work in Process

Work in process, beginning or

Costs of Production Last Month……………………………………. P xx
Add Current Production Costs or Costs of Production This Month:
Direct Materials Used………………………………………………………… P xx
Direct Labor…………………………………………………………………… xx
Applied Factory Overhead…………………………………………………... xx
Total Production Costs P xx
Less Work in process, end…………………………………………………………… xx
Cost of Goods Manufactured P xx

The two schedules illustrated above are often combined as a single schedule of cost of goods
manufactured. This schedule contains no new information from that presented above; it is just a
combination and slight rearrangement of the separate schedules.

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The Schedule of Cost of Goods Manufactured is used to calculate the cost of producing
products for a period of time. Such schedule reports the total manufacturing costs for the period
that were added to work-in-process, and adjusts these costs for the change in the work-in-process
inventory account to calculate the cost of goods manufactured.

Shown below is the Schedule of Cost of Goods Manufactured:

Schedule of Cost of Goods Manufactured

Direct Materials Used: P xx

Materials Inventory Beginning………………………………………. xx
Add Net Purchases of Materials………………………….………… Xx
Materials Available for Use………………………………………….. Xx
Less Materials Inventory End……………………………………….. Xx
Xx
Direct Labor……………………………………………………………………. Xx
Factory Overhead:
Indirect Materials Used……………….……………………………… Xx
Indirect Labor……………….………………………………………… Xx
Factory Utilities……………………………………………………….. Xx
Depreciation of factory assets Xx
Miscellaneous factory overhead Xx
Total Manufacturing Costs or
P xx
Total Production costs Last Month
Add Work in process, beginning or
xx
Total Production Costs Last Month
Cost of goods placed into process P xx
Less Work in process, end Xx
Cost of Goods Manufactured P xx

The cost of goods manufactured is transferred to the finished goods inventory account during the
period and is used in calculating cost of goods sold on the income statement. Manufacturing
companies normally prepare the schedule of costs of goods manufactured before they prepare
the income statement. Shown below is the Schedule of Cost of Goods Sold for a manufacturing
business:

Schedule of Cost of Goods Sold

Finished Goods Inventory Beginning P xx

Add Cost of Goods Manufactured xx
Total Goods Available for Sale or TGAS P xx
Less Finished Goods Inventory End xx
Cost of Goods Sold P xx

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The Schedule of Cost of Goods Sold for a trading or merchandising business will look like this:

Merchandising Inventory Beginning P xx

Add Net Cost of Purchases xx
Total Goods Available for Sale or TGAS P xx
Less Merchandise Inventory End xx
Cost of Goods Sold or Cost of Sales P xx

Cost of Goods Manufactured is the manufacturer’s counterpart to the trader’s Puchases. When
finished goods are sold, their cost is called the Cost of Goods Sold. There are instances when
the beginning and ending inventory balances are not given. Instead, the peso amount of increase
or decrease of an inventory account is provided. Remember, the is increase in inventory when
the Balance End is greater than Balance Beginning o inventory decreases when the Balance End
is less than its Balance Beginning. To illustrate this, assume that Finished Goods Inventory
beginning exceeded its ending balance by P 600,000 and the cost of the completed goods this
month is P 8.6 million. Hence, Cost of Goods Sold is computed as follows:

Cost of Goods Manufactured P 8,600,000

Add Decrease in Finished Goods Inventory 600,000
Cost of Goods Sold P9,000,000

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