COST CONCEPTS

★ Cost Determination & Reporting Methods

• Actual Costing – a valuation method that uses actual direct materials, direct labor, and overhead
charges in determining product cost.

• Normal Costing – a valuation method that uses actual cost of direct materials and direct labor in
conjunction with a pre – determined overhead rate(s) in determining product cost.

• Standard Costing – a valuation method that uses pre – determined norms for direct materials,
direct labor and overhead to assign costs to the various inventory accounts and cost of goods sold.

• Variable Costing (Direct) – a cost accumulation and reporting method that includes only variable
production cost (direct materials, direct labor and variable overhead) as inventoriable or product
cost; is not acceptable for external reporting purposes.

• Absorption (Full) Costing – a cost accumulation and reporting method that treats the cost of all
manufacturing components (direct materials, direct labor and variable and fixed overhead) as
inventoriable or product cost; is the traditional approach to product costing; must be used for
external reporting purposes.

★ Cost Accounting Approaches, Systems & Procedures

• Job Order Costing – a system of product costing used by an entity that provides limited quantities
of products or services unique to a customer’s needs; focus of record keeping is on individual jobs.

• Process Costing – a method of accumulating and assigning costs to units of production in

companies producing large quantities of homogeneous products; accumulates costs by cost
component in each production department and assigns costs to units using equivalent units of
production.

• Activity – Based Costing – a process using multiple cost drivers to predict and allocate costs to
products and services; an accounting system collecting financial and operational data on the basis of
the underlying nature and extent of business activities; an accounting information and costing
system that identifies the various activities performed in an organization, collects costs on the basis
of the underlying nature and extent of those activities, and assigns costs to products and services
based on consumption of those activities by the products and services.

• Just – In – Time System – a philosophy about when to do something; the when is “as needed”
and the something is a production, purchasing, or delivery activity.

• Life Cycle Costing – the accumulation of cost for activities that occur over the entire life cycle of
a product from inception to abandonment by the manufacturer and consumer.

• Backflush Accounting - a streamlined cost accounting method that speeds up, simplifies and
minimizes accounting effort in an environment that minimizes inventory balances, requires few
allocations, uses standard costs, and has minimal variances from standards.

★ Cost Classification

• In relation to the product

▪ Manufacturing costs – are costs involved in making a product. Manufacturing costs can
be
subdivided into three basic elements: direct materials, direct labor, and manufacturing
overhead.
1. Direct materials – include those materials that become an integral part of a
finished product, and can be conveniently traced into it.

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 2. Direct labor – consists of those labor costs that can be easily traced to the
creation of products.

3. Manufacturing overhead – consists of all manufacturing costs except direct

materials and direct labor. Other terms used interchangeably with manufacturing
overhead are factory overhead, factory burden, and indirect manufacturing costs.
Oftentimes, the terms prime cost and conversion cost are used to describe a
combination of some of the elements of manufacturing cost.

4. Prime cost – refers to the sum of direct materials and direct labor costs.

5. Conversion cost – is the sum of direct labor and manufacturing overhead.

▪ Non - manufacturing costs – are those costs involved with selling and administrative
activities.

1. Selling or marketing costs – include all costs associated with marketing finished
products, including commissions, depreciation of delivery equipment,
depreciation of finished goods warehouses, and advertising.

2. Administrative costs – include all costs associated with the general administration
of an organization, including secretarial salaries, depreciation of general
administrative facilities and equipment, and executive compensation.

• For external reporting purposes

▪ Period costs – are costs matched with revenues once incurred. These are normally
referred to as expenses.

▪ Product costs – are costs that are assigned to the products. They are charged to expense
when sold. Until that time, product costs are considered to be assets and are recognized on
the balance sheet as inventory.

• In relation to cost objects

▪ Direct costs – are costs that can be conveniently traced to the cost object under
consideration.

▪ Period costs – are costs that cannot be conveniently traced to the cost object.

• In relation to volume or level of activity

▪ Fixed costs – are costs that remain constant in total within the relevant range but varies
inversely, on a per unit basis, with the volume of activity.

▪ Variable costs – are costs that varies in total in relation to the volume of activity but
remain constant on a per unit basis within a relevant range.

▪ Mixed costs – are costs which have a fixed component and a variable component. These
components are separated by using appropriate methods.

▪ Stepped costs – are costs which are fixed over relatively short ranges of production level.
This cost has both variable and fixed components and is also known as semi – fixed cost.

• In relation to decisions made by managers

▪ Differential costs – are the increases or decreases in total cost, or the changes in specific
elements of cost that result from selecting one alternative instead of another.

▪ Sunk costs – have been defined in two ways: (a) Sunk costs are any cost that will not
change if one alternative is chosen instead of another. (b) Sunk costs are historical costs

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 which are irrecoverable in a given situation. They are costs for which the expenditure of
cash or the incurring of a liability has already taken place.

▪ Avoidable costs – are costs that will not be incurred if a certain decision is made.

▪ Out – of – pocket costs – are costs which will require the expenditure of cash or the
incurring of a liability as a consequence of a management decision.

▪ Opportunity costs – represent the measurable advantage foregone or sacrificed as a result

of the rejection of alternative uses of material, labor, or facilities.

▪ Imputed costs – are costs that do not involve at any time actual cash outlay and which do
not, as a consequence appear in the financial records; nevertheless, such costs involve a
foregoing on the part of the persons whose costs are being calculated.

▪ Historical costs – are costs measured by actual cash payments or their equivalent at the
time of outlay.

▪ Future costs – are costs expected to be incurred at a later date.

▪ Postponable costs – are those costs which may be shifted to the future with little or no
effect on efficiency of current operations.

• In relation to quality management

▪ Prevention costs – are costs incurred in designing programs and activities geared toward
preventing quality problems.

▪ Appraisal costs – are those costs incurred to identify quality problems.

▪ Internal & external failure costs – are those incurred to correct identified quality
problems that are discovered before goods leave the company and those not detected.