ACCTG 6 – Cost Accounting

For BS Entrepreneurship
Prepared by: Manfred Evanz M. Palcat, CPA

Chapter 2
COSTS- CONCEPTS AND CLASSIFICATION

I. Introduction
Costs are associated with all types of organizations – business, non-business,
service, retail/merchandising, 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. The initial focus of the
discussion will be on manufacturing, but 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.

II. Objectives
At the end of this chapter, the student should be able to:
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 of
changes in volume on these costs
6. distinguish between common costs and joint costs
7. distinguish between capital expenditures and revenue expenditures
8. identify the costs for planning, control and analytical processes
ACCTG 6 – Cost Accounting
For BS Entrepreneurship
Prepared by: Manfred Evanz M. Palcat, CPA

Cost, Expenses and Losses

Cost refers to the cash or cash equivalent value sacrificed for goods and services
that are expected to bring a current or future benefit (which usually means
revenue in a profit making firm) to the organization.

Expenses are costs which are used up in the production of revenues and are
described to be expired costs.

Loss is a cost that expires without producing any revenue benefit.

MANUFACTURING COSTS/PRODUCT COSTS/INVENTORIABLE COSTS

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 (examples are flour for bread, sheet steel for
automobiles, iron ore for steel, etc.)

Indirect Materials are minor materials and other production supplies that cannot
be conveniently or economically traced to specific products (examples are nails
in furniture, bolts in automobiles); indirect materials are part of factory overhead.

Direct Labor include all labor costs for specific work performed on products that
can be conveniently and economically traced to end products. Direct labor costs
usually associated with manufacturing include salaries and wages of machine
operators.

Indirect Labor are labor costs for production related activities that cannot be
conveniently and economically traced to end products (examples are wages
and salaries of machine helpers, supervisors, and other support personnel); indirect
labors are accounted for as factory overhead costs.

Factory Overhead is a catchall for manufacturing costs that cannot be classified

as direct materials or direct labor costs; these are a varied collection of
production-related costs that cannot be practically or conveniently traced
directly to end products and are also known as manufacturing overhead, factory
burden and indirect manufacturing costs (examples are building maintenance,
machinery and tool maintenance, property taxes and insurance, pension costs,
depreciation on plant and equipment, rent expense, and utility expense).
ACCTG 6 – Cost Accounting
For BS Entrepreneurship
Prepared by: Manfred Evanz M. Palcat, CPA

Remember!!!

Prime Costs = Direct Materials + Direct Labor

Conversion Costs = Direct Labor + Factory Overhead

Product Cost/Inventoriable Cost

= Direct Material + Direct Labor + Factory Overhead

The three integral components of a product are:

1. Direct Materials
2. Direct Labor
3. Factory Overhead

NON-MANUFACTURING COSTS/PERIOD COSTS

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;
these are often referred to as order-getting and order filling costs (examples are
advertising, shipping, sales travel, sales commissions, sales salaries, and expenses
associated with finished goods warehouses)

Administrative or general expenses include all executive, organizational, and

clerical expense that cannot logically be included under either production or
marketing; examples are executive compensation, general accounting,
secretarial, public relations, and similar expense having to do with the overall
general administration of the organization as a whole.

COSTS CLASSIFIED AS TO VARIABILITY

Fixed costs are items of cost which remain constant in total, irrespective of the
volume of production. Fixed costs are not related to activity (measure of the
organization’s output of products or services) 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 different allocation methods.
Examples are salaries of production executives, depreciation of equipment
computed on a straight-line basis, periodic rent payments, and insurance.
ACCTG 6 – Cost Accounting
For BS Entrepreneurship
Prepared by: Manfred Evanz M. Palcat, CPA

Variable costs are 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.

Mixed cost are 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 cost.

Semi-variable cost are items where 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 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 charges will be made on a per minute basis.
Assume that a company rents a delivery truck at a flat rate of P 30,000 per month
plus P2.00/km. driven. If 10,000 km. are driven during the month, the total monthly
cost of the delivery truck is P 50,000, computed as follows:

Flat fee (fixed portion) P30,000

Variable portion – 10,000 km. x P2.00 20,000
Total cost P50,000

Step costs are items where 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 supervisor’s salary
is an example of step cost. Assume that one supervisor with a salary of P 60,000 is
needed for every 20 workers, then if 30 workers are used, 2 supervisors would be
needed. If the number of workers increases to 42, three supervisors would be
needed.
ACCTG 6 – Cost Accounting
For BS Entrepreneurship
Prepared by: Manfred Evanz M. Palcat, CPA

Methods of Separating Mixed Costs into Fixed and variable Components

1. Scatter graph
2. High-low point
3. Method of least square

Illustration: HIGH-LOW POINT METHOD

Summary of electricity costs and direct labor hours

Month Direct labor hrs. Cost of electricity
January 29 P 620
February 25 560
March 31 625
April 34 635
May 39 680
June 35 635
July 36 650
August 41 695
September 43 710
October 49 740
November 44 695
December 33 625

Computation:
Direct labor hrs. Cost
Highest month (Oct.) 49 P 740
Lowest month (Feb.) 25 560
Difference 24 180

Variable rate per direct labor hour = P 180 / 24 hours

= P 7.50 per direct labor hour

Fixed cost can be computed from either the high or low data, as follows:
High Low
Total cost of electricity P740 P 560
Less: variable proportion
(P7.50 x 49) 367.50
(P7.50 x 25) _______ 187.50
Monthly fixed cost P 372.50 P 372.50
ACCTG 6 – Cost Accounting
For BS Entrepreneurship
Prepared by: Manfred Evanz M. Palcat, CPA

The formula for projecting the total monthly cost of electricity based on these
data would be P372.50 plus P7.50 multiplied by the direct labor hours expected
to be worked during the period (Y = FC + VC or Y = FC + VX) where:
Y = Total cost VC = Total variable cost
V = Variable cost per unit FC = Fixed cost
X = Activity level

Common Cost vs. Joint Cost

Common costs are cost of facilities or services employed in two or more

accounting periods, operations, commodities, or services. Just like indirect
costs, these costs are subject to allocations.

Joint costs are 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.

Capital Expenditure vs. Revenue Expenditure

Capital expenditures are expenditures 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, amortizations for
intangible assets and depletion for wasting assets.

Revenue expenditures are expenditures that will benefit current period only
and is recorded as an expense.

Direct vs. Indirect Department Charges

Direct departmental charges are costs that are immediately charged 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 are costs that are originally charged to some
other manufacturing department(s) or account(s) but are later allocated or
transferred to another department(s) that indirectly benefited from said costs.
ACCTG 6 – Cost Accounting
For BS Entrepreneurship
Prepared by: Manfred Evanz M. Palcat, CPA

Costs for Planning, Control and Analytical Processes

Opportunity cost refers to 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:
Jessa is employed with a company that pays her salary of P25,000 a month.
She is thinking about leaving the company and returning to school for her CPA
review. Since returning to school would require that she give up her P300,000
salaries (25,000 x 12) for the year, the forgone salary would be an opportunity
cost of reviewing for the CPA Board examination.

Differential cost is 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 is known
as decremental cost. Differential cost is a broader term, encompassing both
cost increases and cost decreases between alternatives. 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
more unit of product is called marginal revenue, and the cost involved in
producing one more unit of product is called marginal cost.

Relevant cost is a future cost that change across the alternatives.

Out-of-pocket costs are costs that require the payment of money (or other
assets) as a result of their incurrence.

Sunk cost is a cost for which an outlay has already been made and it cannot
be changed by present or future decision.

Example:
Assume that a firm just paid P1 million for a special purpose machine. Since the
cost outlay has been made, the P1 million investment in the machine is a sunk
cost. Even though the purchase may have been unwise, no amount of regret
ACCTG 6 – Cost Accounting
For BS Entrepreneurship
Prepared by: Manfred Evanz M. Palcat, CPA

can relieve the company of its decision, nor can any future decision cause the
cost to be avoided.

Controllable and Non-Controllable Costs

A cost is considered to be controllable cost of a particular level of

management if that level has the power to authorize the cost. For example,
entertainment expense would be controllable by a sales manager if she or he
had power to authorize the amount and type of entertainment for customers/
on the other hand, depreciation of warehouse facilities would not be
controllable by the sales manager, since he or she would have no power to
authorize warehouse construction.