Chapter one

Cost Terms, Concepts, and Classifications

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In Cost accounting, the term cost is used in many different ways. The reason is
that there are many types of costs, and these costs are classified differently
according to the immediate needs of management.
Managers want cost data to:
1. Prepare planning budgets.
2. Prepare external financial reports.
3. Make decisions.

Therefore we will discuss many of the possible uses of cost data and how
costs are classified for each use as follows:

First: Cost classifications to prepare planning budgets.

(Behavior classifications)

Cost Behavior refers to how a cost will changes as the level of activity change
(number of units produced).

As the activity level rises and falls, a particular cost may rise and falls as well
or it may remain constant. Costs are often classified into:
 Fixed cost
 Variable cost
 Mixed cost

1-fixed cost:
A fixed cost is a cost that remains constant in total regardless the changes in
the number of units produced with in the relevant range.
 The total of fixed cost is constant.
 The fixed cost per unit varies inversely with change in activity (number
of units produced).

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 Example(1): Suppose ABC company rents a machine with capacity 5,000 units per
month for $10,000 per month. The company produced 1,000 units during April and
2,000 units during May.

Month Total Cost Units produced Cost/ unit

(1) (2) (3)= (1)/ (2)
April 10,000 1000 10,000/ 1,000 = 10
May 10,000 2000 10,000/ 2,000 = 5

Total is constant Cost/ unit is variable

The cost of rent is fixed cost

Notes:
1- The total fixed cost can be expressed as an equation:

Y = a

Where: Y= Total fixed cost.

a= The amount of fixed cost.

*The cost of rent equation: Y = $10,000

2- When we say a cost is fixed, we mean it is fixed within relevant rang. In our
example the rent is a fixed cost within the relevant range of 0 to 5000 units per
month. If the company want to produce more then 5000 units per month, it
would be necessary to rent additional machine, which would case a jump in the
fixed costs.

2-Variable cost:
A Variable cost is a cost that changes in direct proportion to changes in the
number of units produced.

 The total of variable cost is variable.

 The variable cost per unit is constant with change in activity (number of
units produced).
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 Example(2): suppose XYZ company manufactures tables. The units produced and
the costs of Wood during April and May are given below:
Units produced Total costs of Wood
April 100 tables $ 10,000
May 200 tables $ 20,000

Total costs Units produced Cost/ unit

(1) (2) (3)= (1)/ (2)
April $10,000 100 $ 100
May $20,000 200 $ 100

Total is variable Cost/ unit is constant

The cost of Wood is variable cost

Notes:

-The total variable cost can be expressed as an equation:

Y = bX

Where: Y= Total variable cost.

b= The variable cost per unit of activity.
X= The level of activity (Production volume)

*The cost of wood equation:

Y = 100 X

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5
 Exercise (1): Adham Company produces and sells a single product. A partially
completed schedule of the company’s total and per unit costs over the relevant
range of 30,000 to 50,000 units produced and sold annually is given below:

Units Produced and Sold

30,000 40,000 50,000
Total costs:
Variable costs $ 210,000 ? ?
Fixed costs 300,000 ? ?

Total costs 510,000 ? ?

Cost per unit:

Variable cost ? ? ?
Fixed cost ? ? ?

Total Cost ? ? ?

Required:
Complete the schedule of the company's total and unit costs above.
Answer
- The variable cost/ unit = $210,000 ÷ 30,000 unit = $7 per unit

- The Variable cost equation Y = 7X

40,000 Units 50,000 units
The total variable cost 40,000 X 7 = $280 000 50,000 X 7 = $350,000

- The total of fixed costs does not change with changes in the units produced.
They remain constant at $300,000 within the relevant range.

- The fixed cost per unit = Total Fixed cost ÷ Units produced

Total Fixed Cost Units produced Cost per unit

(1) (2) (3) = (1) ÷ (2)
300,000 30,000 300,000 ÷ 30,000 = $ 10
300,000 40,000 300,000 ÷ 40,000 = $ 7.5
300 000 50 000 300,000 ÷ 50,000 = $ 6

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*Therefore the missing amounts are as follows:

Units Produced and Sold

30,000 40,000 50,000
Total costs:
Variable costs $ 210,000 280,000 350,000
Fixed costs 300,000 300,000 300,000

Total costs 510,000 580,000 650,000

Cost per unit:

Variable cost 7 7 7
Fixed cost 10 7.5 6

Total Cost per unit 17 14.5 13

Notes:
- Total costs = Variable cost + Fixed cost
- Total cost per unit = Variable cost per unit + Fixed cost per unit

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 3-Mixed cost (Semivariable cost):
A mixed cost is a cost that changes in total with changes in the number of units
produced but not in direct proportions.

 The total of mixed cost is variable.

 The mixed cost per unit is variable.

Example(3): suppose XYZ company manufactures tables. The units produced and the cost of
maintenance during April and May are given below:

Units produced Total costs of maintenance

April 100 tables $10,000
May 200 tables $15,000

Total costs Units produced Cost/ unit

(1) (2) (3)= (1)/ (2)
April $10,000 100 $10
May $15,000 200 $7.5

Total is variable Cost/ unit is variable

The cost of maintenance is mixed cost

Notes:
1- Mixed cost contains both variable and fixed cost elements.
2- The total Mixed cost can be expressed as an equation:

Y = a + bX

Where: Y= The total mixed cost.

a= The total fixed cost.
b= The variable cost per unit of activity.
X= The level of activity (Production volume)

3- We will use High-Low Method to analysis mixed cost (How?)

- Step (1) choose the highest level and lowest level of activity

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 - Step (2) Estimate the variable cost per unit (b)

Cost at High Level - Cost at Low Level

b =
High Level of Activity - Low Level of Activity

- Step (3) compute the fixed cost by function Y = a + bX

(By using either the highest level or the lowest level)

Exercise (2): Assume the following information for maintenance cost and
maintenance hours for 2018.
Quarter Total Maintenance cost Hours of Maintenance

1 $ 60,000 10,000
2 70,000 12,000
3 65,000 11,000
4 50,000 8,000
Required:
1- Using the high low method estimate a cost formula.
2- Using cost formula what will be the estimated Maintenance cost at
13,000 hours?
Answer
(1)
Step (1): Determine the highest and lowest activity and the mixed cost related
to them.
Hours Cost

Highest Level 12,000 70,000

Lowest Level 8,000 50,000
Step (2): Compute variable cost/ unit (b)

Cost at High Level - Cost at Low Level

b =
High Level of Activity - Low Level of Activity

$70,000 – $50,000
b= = $5/ hour
12,000 – 8,000

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Step (3): Calculating fixed cost

 By using the highest level

Y =a+ bX

$70,000 = a + (5 * 12,000 hours)

70,000 – 60,000 = a
a= $10,000

Y = 10,000 + 5 X

Note: We can reach the same result by using the lowest level.
Y =a+ bX

$50,000 = a + (5 * 8,000 hours)

50,000 – 40,000 = a
a= $10,000

Y = 10,000 + 5 X

(2)
Y = 10,000 + 5 X
Y = 10,000 + (5 * 13,000)
Y = 10,000 + 65,000
Y = $75,000

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Second: Cost classifications to prepare external financial reports.

To prepare external financial reports costs are often classified into:

1. Manufacturing costs (Product costs)
2. Non manufacturing costs (Period costs)

1- Manufacturing costs or Product costs include all the costs that are
involved in making a product. More specifically, it includes:

- Direct material (DM): Raw materials that become an integral part

of the finished product and whose costs can be conveniently
traced to it. (Ex. Wood in furniture industry).

- Direct labor (DL): Direct labor is the wages paid to workers who
spend time working on the product

Example: Wages paid to machine operators

- Indirect manufacturing overhead (MOH): Includes all

manufacturing costs except direct materials and direct labor.
These costs cannot be easily traced to specific units produced
(also called indirect manufacturing cost, factory overhead, and
factory burden).(Ex. Indirect material, indirect labor cost, rent of
plant, depreciation and insurance on manufacturing facilities, etc.)

Notes:
1- prime cost = Direct material + Direct labor
2- Conversation cost = Direct labor + indirect manufacturing overhead
3- manufacturing cost= DM + DL+ MOH
B- Non manufacturing Costs: includes
 Selling costs- includes all costs necessary to secure customer orders and
get the finished product into the hands of the customer (Ex. Advertising,
Shipping, sales travel, sales commissions, sales salaries, etc.).

 Administrative costs - includes all executive, organizational, and clerical

costs associated with the general management of an organization.

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3- Product cost and period cost
 Product cost – includes all the costs that are involved in acquiring or
making a product. More specifically, it includes direct materials, direct
labor, and manufacturing overhead. These costs are capitalized as asset
(inventory) until they are sold and transferred to cost of goods sold.

 Period cost– includes all marketing or selling costs and administrative

costs. These costs are expensed on the income statement in the period
incurred. Have no future value.

Types of manufacturing inventory

 Raw material inventory: consists of materials being held by the company,

ready to be used in the manufacturing process.
 Work in process (WIP) inventory: Consists of units of product that are
partially complete, but will require further work to be saleable to
customers (products started but not yet completed).
 Finished goods inventory: Consists of units of product that have been
completed but not yet sold to customers.

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How to prepare income statement in manufacturing company:

To prepare income statement we must calculate cost of goods manufactured as

follows:
Schedule of Cost of goods manufactured
Beginning direct material inventory XX
(+) purchases of direct material XX

Direct material available for use XX

(-) Ending direct material inventory (XX)
Direct material used XX
+
Direct labor XX
+
Manufacturing overhead(such as:)
Indirect material XX
Indirect labor XX
Factory depreciation XX
Factory utilities XX
Factory rent XX
Factory supplies XX
XX
Total manufacturing cost XX
+ Beginning work in process (WIP) inventory XX
- Ending work in process (WIP) inventory (XX)

Cost of goods Produced (manufactured XX

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 Income statement: (Manufacturing Company)
Revenue XX
(- )Cost of goods sold
Beginning finished goods inventory XX
(+)Cost of goods manufactured XX

Cost of goods available for sale XX

(-) Ending finished goods inventory (XX)
Cost of goods sold (XX)

Gross profit XX
(-) Selling and administrative expenses (XX)

Operating income XX

Exercise (4): The following data related to ABC Company

Direct labor cost $85,000
Purchases of direct materials 132,000
Rent, factory building 20,000
Indirect labor 22,000
Utilities, factory 8,000
Repair, factory equipment 7,000
Supplies, factory 4,000
Depreciation, factory equipment 9,000
Sales Revenue 400,000
Selling and administrative expenses 20,000

Beginning of Year End of Year

Inventories:
Raw materials $8,000 $5,000
Work in process 5,000 20,000
Finished goods 25,000 5,000

Required:
1. Prepare a schedule of cost of goods produced.
2. Determine the amount of prime cost and conversion cost.
3. Prepare income statement
Answer

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 Cost of goods produced schedule
Beginning direct material inventory 8,000
(+) purchases of direct material 112,000

Direct material available for use 120,000

(-) Ending direct material inventory (5,000)
Direct material used 115,000
+
Direct labor 85,000
+
Manufacturing overhead
Rent, factory building 20,000
Indirect labor 22,000
Utilities, factory 8,000
Repair, factory equipment 7,000
Supplies, factory 4,000
Depreciation, factory equipment 9,000

70,000
Total manufacturing cost during the year 270,000
+ Beginning work in process (WIP) inventory 5,000
- Ending work in process (WIP) inventory (20,000)
Cost of goods manufactured 255,000

Income statement: (Manufacturing Company)

Revenue 400,000
(- )Cost of goods sold
Beginning finished goods inventory 25,000
(+)Cost of goods manufactured 255,000

Cost of goods available for sale 280,000

(-) Ending finished goods inventory (5,000)
Cost of goods sold (275,000)

Gross profit 125,000

(-) Selling and administrative expense (20,000)

Operating income 105,000

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 Third: Cost Classifications for Decision making
In making decisions, it is essential to have a firm grasp of the concepts
differential cost, sunk cost, and opportunity cost.
1- Differential cost
- Differential cost is a cost that vary from alternative to another.
- Differential cost can be either fixed cost or variable.
- It is relevant cost for decision making.
- It should be considered when making a decision

2- Sunk cost
- Sunk cost is a cost that not vary from alternative to another.
- Sunk cost can be either fixed cost or variable.
- It is irrelevant cost for decision making.
- It should be ignored when making a decision.
Example(1):
ABC Company is thinking about changing its marketing method from distribution
through retailers to distribution by door- to- door direct sale. Present costs are
compared to projected costs in the following table:

Retailer Direct sale

distribution distribution
(Present) (Proposed)
Cost of goods sold 300,000 400,000
Advertising 80,000 40,000
Commissions 0 30,000
Warehouse deprecation 50,000 50,000
Other expenses 40,000 40,000

Required: Determine the type of each cost (Differential cost or Sunk cost)
Answer
Retailer Direct sale
distribution distribution Type of cost
(Present) (Proposed)
Cost of goods sold 300 000 400 000 Differential cost
Advertising 80 000 40 000 Differential cost
Commissions 0 30 000 Differential cost
Warehouse dep. 50 000 50 000 Sunk cost
Other expenses 40 000 40 000 Sunk cost

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3- Opportunity cost
- Opportunity cost is the potential benefit that is given up when one alternative
selected over another.

Example(2):
Ahmed works from 3 pm: 9 pm at $ 10 per hour. He is thinking about going to
the cinema from 6 pm: 9 pm. Ticket price $ 25

-What is cost of going to the Cinema?

Answer
Since going to Cinema would require that Ahmed give up part of his salary
= 3 hours X $10 = $ 30 Opportunity cost
Therefore the total cost of going to the Cinema =

Ticket Price $ 25
+
Opportunity cost $ 30
Total cost of going to the Cinema $ 55

- Opportunity cost must be considered when making a decision.

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 Assignments
Exercise (1):
The following information is taken from the books of Alfredo Company:

Beginning of End of
2015 2015
Direct Material Inventory $ 22,000 $27,000
Work in process inventory 15,000 25,000
Finished goods inventory 17,000 24,000
Additional information:
Sales Revenue 240,000
Purchases of direct materials 75,000
Direct manufacturing labor 30,000
Indirect manufacturing labor 16,000
Insurance, Factory 9,000
Depreciation- building, equipment, Factory 11,000
Repairs and maintenance- Factory 4,000
Selling costs 12,000
General and administrative cost 24,000
Instructions:
1. Prepare a schedule for the cost of goods manufactured for 2015.
2. Determine the amount of prime cost and conversion cost.
3. Prepare the income statement for 2015.

Exercise (2): Listed below are costs found in various organizations.

1. Depreciation, factory equipment.
2. Wood used in manufacturing furniture.
3. Electricity used in manufacturing furniture.
4. Secretary to the company president.
5. Rent, factory.
6. Supervisor’s salary, factory.
7. Sales commissions.
8. Advertising costs.
Required:Prepare an answer sheet with column headings as shown below. For
each cost item, indicate whether it would be variable or fixed with respect to
the number of units produced and sold; and then whether it would be a selling
cost, an administrative cost, or a manufacturing cost. If it is a manufacturing
cost, indicate whether it would typically be treated as a direct or indirect cost

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 with respect to units of product.
Answer
Cost Item Variable Selling Administrative Manufacturing
or Fixed Cost Cost (Product) Cost
Direct Indirect
1- Depreciation, factory
equipment.
2-Wood used in
manufacturing furniture.
3- Electricity used in
manufacturing furniture.
4-Secretary to the
company president.
5- Rent, factory.
6-Supervisor’s salary,
factory.
7- Sales commissions.
8- Advertising costs.

Exercise (3): Multiple Choice Questions

1- Which of the following is correct concerning reactions to INCREASES in activity?
Total Variable Cost Variable Cost Per Unit
A) Increases Decreases
B) Constant Decreases
C) Decreases Constant
D) Increases Constant

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2- Conversion costs consist of:
A) direct and indirect labor.
B) direct labor and direct materials.
C) direct labor and manufacturing overhead.
D) prime costs and manufacturing overhead.

3- Direct costs:
A) are incurred to benefit a particular accounting period.
B) are incurred due to a specific decision.
C) can be easily traced to a particular cost object.
D) are the variable costs of producing a product.

4-Manufacturing overhead includes:

A) all direct material, direct labor and administrative costs.
B) all manufacturing costs except direct labor.
C) all manufacturing costs except direct labor and direct materials.
D) all selling and administrative costs.

5-The information below relates to Derby Manufacturing Company's operations

for a recent month. (Assume that all raw materials are direct materia
Purchases of raw materials .......................... $91,000
Direct labor cost ............................................... $122,000
Selling costs (total) .......................................... $42,000
Administrative costs (total) ........................ $56,000
Manufacturing overhead costs (total) .... $340,000
Raw materials inventory, beginning........... $22,000
Work in process inventory, beginning ..... $27,000
Finished goods inventory, beginning ......... $42,000
Raw materials inventory, ending................. $7,000
Work in process inventory, ending............ $35,000
Finished goods inventory, ending ............... $15,000

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 What was Derby's cost of goods manufactured for the month?
A) $545,000
B) $560,000
C) $568,000
D) $587,000

6-The following costs were incurred in July:

Direct materials .................................. $35,000
Direct labor........................................... $13,000
Manufacturing overhead ................. $15,000
Selling expenses.................................. $14,000
Administrative expenses ................ $30,000

Prime costs during the month totaled:

A) $48,000
B) $28,000
C) $107,000
D) $63,000

Use the following to answer questions 7-10:

The following data (in thousands of dollars) have been taken from the accounting
records of Karling Corporation for the just completed year.
Sales......................................................................... $990
Raw materials inventory, beginning ........... $40
Raw materials inventory, ending ................. $70
Purchases of raw materials .......................... $120
Direct labor .......................................................... $200
Manufacturing overhead ................................ $230
Administrative expenses................................ $150
Selling expenses ................................................. $140
Work in process inventory, beginning...... $70
Work in process inventory, ending ............ $50
Finished goods inventory, beginning ......... $120
Finished goods inventory, ending ............... $160

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7. The cost of the raw materials used in production during the year (in
thousands of dollars) was:
A) $190
B) $90
C) $150
D) $160

8.The cost of goods manufactured (finished) for the year (in thousands of
dollars) was:
A) $540
B) $500
C) $570
D) $590

9.The cost of goods sold for the year (in thousands of dollars) was:
A) $700
B) $500
C) $660
D) $580
10.The net operating income for the year (in thousands of dollars) was:
A) $150
B) $200
C) $490
D) $250
Use the following to answer questions 11-13:
Johnson Company has provided the following data for the first five months of
the year:
Machine Hours Lubrication Cost
January ................... 120 $750
February ................. 160 $800
March ..................... 200 $870
April ....................... 150 $790
May......................... 170 $840
11.Using the high-low method of analysis, the estimated variable lubrication cost
per machine hour is closest to:
A) $1.40
B) $1.25
C) $0.67
D) $1.50

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12.Using the high-low method of analysis, the estimated monthly fixed
component of lubrication cost is closest to:
A) $570
B) $560
C) $585
D) $565

13.Total lubrication cost for an activity level of 180 machine hours would be:
A) $840
B) $270
C) $570
D) $565

14.Utility costs at Service, Inc. are a mixture of fixed and variable components.
Records indicate that utility costs are an average of $0.40 per hour at an
activity level of 9,000 machine hours and $0.25 per hour at an activity level of
18,000 machine hours. Assuming that this activity is within the relevant range,
what is the expected total utility cost if the company works 13,000 machine
hours?
A) $4,225
B) $5,200
C) $4,000
D) $3,250
15. Which of the following statements about product costs is true?
A) Product costs are deducted from revenue when the production process is
completed.
B) Product costs are deducted from revenue as expenditures are made.
C) Product costs associated with unsold finished goods appear on the
balance sheet as assets.
D) Product costs appear on financial statements only when products are sold.

16.The one cost that would be classified as part of both prime cost and
conversion cost would be:

A) indirect material.
B) direct labor.
C) direct material.
D) indirect labor.
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17.ABC Company provided the following information for last month:
Sales revenue $20,000
(-)
Variable costs (7,000)
Fixed costs (8,000)
Net operating income $5,000

If sales double next month, what is the expected net operating income?
A) $10,000
B) $25,000
C) $18,000
D) $13,000

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