Chapter 1

COSTS CONCEPTS AND COST CLASSIFICATIONS

Learning Objectives:
At the end of the chapter, the students are expected to have learned the following:
1. Explain the scope and state the objectives of cost accounting;
2. Distinguish between financial, managerial and cost accounting;
3. Differentiate the classification of costs;
4. Separate mixed costs into its variable and fixed components;
5. Differentiate elements of product costs in a manufacturing company;

COST ACCOUNTING
Cost Accounting is defined in many ways but its main function is to determine how much an object,
project or service cost. Cost accounting is not limited only to manufacturing and construction companies
but it is also applicable to service type of businesses, like hospitals, educational institutions, hotels and
resorts, restaurants, legal and other professional offices, medical and dental clinics and many more.

Cost Accounting is a discipline that focuses on techniques or method for determining the cost of a project,
process, or services for the purpose of planning and controlling activities, improving quality and
efficiency, and for making decisions. It provides information on a company’s cost and may be used for
both internal and external purposes.

According to Horngren, Cost Accounting measures and reports financial and nonfinancial information
relating to the cost of acquiring or consuming resources in an organization. It provides information on a
company’s cost and may be used for both internal and external purposes.

Rayburn states that Cost Accounting identifies, defines, measures, reports, and analyzes the various
elements of direct and indirect costs associated with producing and marketing goods and services. It also
measures the performance, product quality and productivity.

COMPARISON OF FINANCIAL, MANAGERIAL AND COST ACCOUNTING

There are two major areas of accounting (1) financial accounting and (2) managerial accounting.

Financial Accounting is the use of accounting information for reporting external parties, including
investors and creditors. Financial accounting is primarily concerned with financial statements for external
use by those who supply funds to the entity and other persons who may have vested interest in the
financial operations of the firm. The suppliers of funds include stockholders (the owners of the
corporation) partners (the owners of the partnership) and sole proprietors. Creditors who provide debts are
also interested on the financial statements of the entity. The financial statements are the output from an
accounting system. The reports prepared under financial accounting focus on the enterprise as a whole.
Financial accounting is based on historical transaction data. The information may be historical,
quantitative, monetary and verifiable. The data are historical and are supported by documents (evidence).
The information provided by financial accounting is usually presented in the form of financial statements,
tax returns, and other formal reports distributed to various external users. The same infor5mation may
also be used internally to provide a basis for financial analysis by management.

Financial accounting is required for many firms organized as corporations because of the requirements of
the Securities and Exchange Commission.
The Bureau of Internal Revenue also requires financial accounting information for compliance with the
country’s tax laws. Information based on accounting data is required for all firms without regard to their
size.

Managerial Accounting focuses on the needs of parties within the organization, rather than interested
parties outside the organization. Managerial accounting information commonly addresses individual or
divisional concerns rather than those of the enterprise as a whole. The information may be current or
forecasted, quantitative or qualitative, monetary or non-monetary and most of all the data are futuristic
and some of the costs are not recorded on the accounting books of the organization.

Managerial accounting is not separate and distinct from financial accounting. Financial accounting data
are used in the managerial accounting system. Management decisions made today will affect the financial
statement of future periods. There is no requirement or legislation that mandates the format or use of
managerial accounting. Managerial accounting methods are tools that are available for use to
management.

Financial accounting attempts to present some degree of precision in reporting historical information
while at the same time emphasizing verifiability and freedom from bias in the information, relevance to
the general user and some degree of timeliness in reporting which is not as critical in managerial
accounting. The timing of information and its relevance to the decision on hand has greater significance
to the internal decision-maker. Management is more concerned on the timeliness of the information so
management cannot wait until tomorrow for information that is required for today’s decision.

The measuring based in managerial accounting does not necessarily have to be restricted to pesos.
Various bases may be appropriate to report managerial information. Examples include: (1) an economic
measure such as pesos; (2) a physical measure such as pounds, gallons, tons or units; and (3) a
relationship measure such as ratios.

Cost Accounting is the intersection between financial and managerial accounting. Cost accounting
information is needed and used by both financial and managerial accounting. Cost accounting information
is needed and used by both financial and managerial accounting. Cost accounting provides product cost
information to external parties, such as stockholders, creditors and various regulatory boards for credit
and investment decisions. Cost accounting provides product cost information also to internal parties such
as managers for planning and controlling.

Financial Cost Management

Accounting Accounting Accounting

USES OF COST DATA

Accurate cost information is important whether a company engages in service, merchandising or
manufacturing operations. Each of these industries has the same basic financial statements which
normally consist of Income Statement, Statement of Changes in Owner’s Equity, Balance Sheet and
Statement of Cash Flows.

Cost accounting information is very useful in determining product and service costs and in setting prices
for the product and the service. Knowing the costs of a product or service helps the management set the
selling price enough to recover the cost of production, cost of performing a function, distribution,
administration and to provide allowance for reasonable profit. These costs information also help the
management in deciding whether to maintain, to reduce or to increase the selling price in order to have a
fair competition in the market.

The accumulated costs information is summarized and reported to the management for effective planning
to attain the company’s goal and objectives. In manufacturing, if the management has sufficient
information about cost data, it can prepare a detailed production plan, which usually includes the
following

(a) The number of units to be produced

(b) The type of manufacturing operations to be performed
(c) The desired quality of the product
(d) The number of personnel to be utilized (laborers and non-laborers)
(e) The level of materials inventory to be maintained in order not to encounter overstocking or stock-
out of materials
(f) The delivery schedules
(g) Other productive schedules

Once a production plan has been laid out, it would be easier for the management to perform the function
of control where actual results are compared with expected results set by the management to allow the
management team to make corrective action measures on areas where significant differences are noted. In
controlling, responsibility is assigned to different departments or groups of workers who has control over
and accountable for the costs charged to that department or group. In this manner, the accountability for
costs or production results is easily identified.

CLASSIFICATIONS OF COSTS
Cost classification is very essential in summarizing the cost data gathered. The costs of an object, product
or service represent the cash or cash equivalent of resources used in acquiring the goods, manufacturing a
product and performing a function. It also includes the cost of distributing the product or services to the
ultimate consumers. The cash equivalent is used because non-cash assets can be exchanged for the desired
goods or services.

Product Cost

Manufacturing Cost is the sum of the inputs or resources used in the conversion of raw materials into
finished goods. This type of cost is often referred to as product cost or inventoriable cost. The product
costs include cost of direct materials, direct labor and factory overhead. The accumulated cost of direct
materials, direct labor and factory overhead is summarized in a Work in Process account. At the end of a
period, the cost of completed goods is transferred to the finished goods account. The sold portion of the
finished goods is reported as expense in the Income Statement as Cost of Goods Sold, while the unsold
goods are reported in the Balance Sheet as Finished Goods. The cost of unfinished goods is left in the
Work in Process account which is also reported in the balance sheet as current assets.

A manufacturing company normally maintains three inventory accounts. These are: Finished Goods,
Work in Process and Raw Materials. The finished goods and work in process account are already
discussed in the preceding paragraph while Raw Materials represent the unused portion of direct and
indirect materials.

For a retailing or merchandising company (a company engaged in buying goods ready for sale), product
costs include the purchase price of goods bought for resale plus the transportation cost and other direct
costs incurred in bringing the goods to the place of the buyer.
For a construction company (a company engaged in constructing buildings, bridges and other related
structures), the product costs include the cost of construction materials. Labor of carpenters and overhead
incurred in construction like cost of power, light and water, insurance, hospitalization and other health
benefits for workers, maintenance of construction equipment, compensation of foreman, cost of
constructing temporary house for the workers and for construction materials, depreciation of equipment,
rentals and other expenses incurred in the construction site.
For a service organization, its product costs are classified either as direct or indirect costs. Their inventory
accounts are usually for supplies like office supplies for accounting firms or law firms, medical supplies
for hospitals and medical clinics, cleaning supplies for utility firms and food supplies for restaurants and
bars. They don’t maintain work in process account nor finished goods inventory account like the
manufacturing company because their operation requires only service. The most significant portion of
their costs is labor because the workers utilized their own efforts in delivering the service. Below is the
classification of product costs in a manufacturing company.

Elements of Product Costs: Manufacturing Company

1. Materials. Materials include the raw materials and other factory supplies used in manufacturing
operation. They are classified as:

(a) Direct Materials. Direct materials are those materials traceable to the Product being
produced. Examples: lumber in the manufacture of furniture; galvanized iron and steel in the
manufacture of jeepneys and trucks; leather in the manufacture of bags, belts, wallets and
shoes; fabrics in the manufacture of shirts, dresses, coats and other related gents and ladies’
apparels; flour, sugar and butter in the manufacture of bread and other pastries and many
more.

(b) Indirect Materials. These are materials necessary in manufacturing operations but are not
directly included in or not a significant part of the product. They include operating, janitorial
and factory supplies used in the factory such as nails, screws, washers, glue, sand paper,
lubricating oil, grease, cleaning materials and other materials needed to maintain the working
area and plant equipment in a usable and safe condition. The costs of indirect materials are
relatively small in relation to the cost of all other raw materials.

2. Labor. Labor represents the compensation and other benefits paid to the workers in the factory.
They are classified as:

(a) Direct Labor. Direct labor represents compensation and benefits paid to those who physically
work on the conversion of raw materials into finished product and are easily traceable to a
specific process or job order. They include the basic pay, cost of living allowance, 13 th month
pay and cash equivalents of non-cash incentives given on a regular basis.

(b) Indirect Labor. Indirect labor represents wages of personnel other than the direct labor, which
are necessary to the manufacturing process or service but are not directly related to the actual
conversion of raw materials into a finished product. They include supervisor’s fee, wages
paid to other workers such as janitors, inventory control clerks, guards, and other personnel in
the factory, employee benefits such as employer’s share in SSS, PhilHealth and Pag-IBIG,
vacation and holiday pay, health insurance of workers, educational benefits, overtime and
night premiums, cost of housing and accommodation for stay-in workers, and performance
bonuses for deserving worker. Most manufacturing companies find it more convenient to
treat employee benefit costs accruing to direct labor workers.

3. Manufacturing Overhead. Manufacturing overhead is an indirect product cost and it includes

production cost other than direct materials and direct labor. They include:
 (a) Factory supplies such as oil and other cleaning materials used in the factory.
(b) Wages of supervisors, factory maintenance personnel, raw materials handlers and security
officers stationed in the factory premises.
(c) Depreciation of factory plant and equipment
(d) Insurance and property taxes on factory plant and equipment.
(e) Maintenance and repairs on factory plant and equipment
(f) Power, light and water
(g) Telephone and mailing costs
(h) Cost of regulatory compliance such as meeting factory safety requirements and disposal of
waste materials.
(i) Idle time by factory workers due to machine breakdowns or new set ups which are
unavoidable in production process. During their idle time, the workers are not productive
therefore the cost is spread over the entire production not to specific product.

Prime Costs – is the sum of direct materials and direct labor.

Conversion Costs – is the sum of direct labor and factory overhead.

Period Costs

Period costs are operating expenses that are associated with time periods, rather than with the production
of goods and services. Period costs are charged directly to expense accounts on the assumption that their
benefit is recognized entirely in the period when the cost is incurred. They are non-manufacturing costs
and non-inventoriable costs. They include:

(a) Marketing and Selling Costs. These are the costs of getting and filling orders such as cost of
customer service, cost of documentation, salaries and commissions of sales personnel, advertising
costs and other expenses associated with the sale of the goods and services.
(b) Distribution Costs. These are costs of warehousing, transporting and delivering a product or
service.
(c) Administrative Costs. These are costs associated with the general administration of the
organization that cannot be reasonably assigned to either marketing or production such as salaries
and wages of administrative officers and employees, power and water consumption,
transportation and representation expenses, maintenance cost of office equipment, depreciation of
office furniture and equipment, taxes and licenses, gas and oil expenses and other expenses in the
administrative offices.

Direct Costs and Indirect Costs

Direct Cost. Direct costs are costs that can be obviously and physically traced to a manufacturing process,
job or order, business unit, segment or department. These costs are often described as those that would be
saved if the segment or business unit would be discontinued or if the product would not be manufactured.
Direct costs are not only direct materials and direct labor but it also includes the cost to a run a business
unit. They include:

(a) Salary of auto mechanics in Automotive Servicing Co.

(b) Salary of a binder in a Printing Company
(c) Oil and lubricants in a Trucking Company
(d) Steel bars used by a Construction Company
(e) Bond papers and telephone expense in a Law Office
(f) Cost of detergents in a laundry shop
(g) Cost of x-ray, doctor’s fee, laboratory fee and medicine in a hospital
Indirect Costs. These are cost related to a particular cost object but cannot be traced to that cost object in
an economically feasible way. They are normally incurred for the benefit of several segments within the
organization. In a manufacturing company, these are the overhead costs incurred in the process of
production.

Common Costs and Joint Costs

Common Costs. Common costs (Allocated cost or departmental cost) are mutually beneficial costs, which
occur when the same resource is used in the output of two or more services or products, or simply the
costs of facilities or services shared by two or more departments or operations. Examples of common cost
are:

(a) Building repairs and maintenance costs

(b) Rent of a building occupied by different departments
(c) Power and utilities costs
(d) Salaries and wages of personnel serving two or more departments
(e) Real Estate taxes for land and building
(f) Permit and Licenses

Joint Costs. Joint costs are costs incurred in a single process that yields two or more products. They are
production costs (direct materials, direct labor and factory overhead) incurred up to the point where
products are separately identified. For example:

(a) The cost of dough

(b) Labor of baker
(c) Overhead incurred by a bakeshop

Opportunity Costs and Sunk Costs

Opportunity Costs. Opportunity costs represent the benefits foregone because one course of action is
chosen over another. Examples are:

(a) The rent revenue foregone if a company decides to use a part of a building rather than leasing it.
(b) The salary foregone if a student decides to be a full-time student rather than a working student

Sunk Costs. Sunk cost are costs that have already been incurred and cannot be changed or avoided by any
future decision. They are past costs that are unavoidable because they cannot be changed no matter what
action is taken by the management. Examples are:

(a) The acquisition cost of an office equipment

(b) The manufacturing costs of finished goods on hand

Committed Costs and Discretionary Costs

Committed Costs. Committed costs are costs resulting from an organization’s structure or use of facilities
and its basic organization structure. Examples are:

(a) Property taxes

(b) Depreciation on building and equipment
(c) Salaries of management personnel
(d) Cost of renting facilities

Discretionary Costs. These are costs resulting from management decision to spend a particular amount of
money for a specific purpose. Examples are:
 (a) Amount of money to spend on Research and Development
(b) Management development program and contributions to charitable institutions
(c) Advertising and promotions

Controllable Costs and Non-controllable Costs

Controllable Costs. Controllable costs are costs that are primarily subject to the influence of a given
responsibility center manager for a given period of time. Examples are:

(a) The cost of raw materials used in manufacturing leather products. The production manager has
the ability to control the materials to be used in production by selecting only materials with high
quality, thus, reducing waste and spoilage.
(b) Cost of food in the factory canteen. The canteen manager has the ability to control losses in terms
of spoilage and theft by canteen personnel.

Non-controllable Costs. These are costs that cannot be controlled or influenced by a responsibility center
manager. Example:

(a) Cost of renting equipment. The owner of the equipment has the control over the amount of rent
not the production manager.

Out of Pocket Costs and Budgeted Costs

Out of Pocket Costs. These costs refer to the cash outlay required to complete a proposed project or to
extend an activity undertaken.

Budgeted Costs. These refer to planned or predetermined costs.

Capital Expenditure and Revenue Expenditure

Capital Expenditure. These are expenditures intended to benefit future periods and are reported as asset in
the balance sheet. Examples are:

(a) Cost of overhauling heavy equipment

(b) Cost of replacing worn out wall of a building

Revenue Expenditure. These are expenditures that benefit only the current period and are reported as
expense.

Fixed, Variable and Mixed Costs

Fixed Costs. These are costs that are constant in total within the relevant range of activity but variable on
a per unit basis. As the activity level increases or decreases, total fixed cost remains constant but unit cost
declines or goes up. Examples are:

(a) Depreciation using the straight-line method

(b) Factory rent
(c) Factory insurance
(d) Supervisory fee
(e) Wages of indirect laborers
(f) Factory taxes
Illustration 1. Assume the following:
Total fixed cost for the period P100,000
Production in units:
Case 1 8,000
Case 2 9,000
Case 3 9,500
Relevant Range : 8,000-10,000 units

Case 1 Case 2 Case 3

Total Fixed Cost P100,000 P100,000 P100,000
Production in unit 8,000 9,000 9,500
Fixed Cost per unit 12.50 11.11 10.53

Observations: Take note that the total fixed costs remain the same but the fixed cost per unit decreases as
production increases within the relevant range.

Variable Costs. These are costs that vary in total in direct proportion to changes in the volume of
production. Variable cost is a constant amount on a per unit basis as activity changes within a relevant
range. As activity changes, total variable cost increases or decreases proportionately with the activity
change, but unit variable costs remain the same. Examples are:

(a) Direct materials and direct labor

(b) Fuel and other factory supplies
(c) Overtime premium
(d) Materials handling costs
(e) Maintenance costs

Illustration 2. Assume the following:

Variable cost per unit:

Direct Materials P 5.00
Direct Labor 6.00
Overhead 3.00
Total Variable Costs 14.00

Case 1 Case 2 Case 3

Production in unit 8,000 9,000 9,500
Variable cost per unit 14.00 14.00 14.00
Total Variable Costs 112,000 126,000 133,000

Observations: The variable cost per unit is constant at P14.00 per unit, but as production increases, total
variable costs also increases.

Relevant Range is defined as a limited range of activity within which expenditures can be accurately
classified as fixed cost or variable or the range over which an assumed cost relationship is valid for the
normal operations of a firm.

Mixed Costs or Semi-variable Costs. These are costs that have both fixed and variable component like
heat, light and water expense.

Separating Mixed Cost

When a cost is classified as mixed, it is appropriate to separate the fixed cost from the variable cost. One
of the methods in separating mixed costs is the high-low method. The procedure starts from selecting the
highest and lowest levels of activity in a given set of data within the relevant range. Then, determine the
changes in activity and cost by subtracting low values from high values. These changes are used to
calculate the variable unit cost. This value is then multiplied by the activity level to determine the amount
of total variable cost contained in the mixed cost at either high or low level of activity. The fixed portion
of the mixed cost is calculated by subtracting total variable cost from total mixed costs.

Variable cost per unit: Cost at high level – Cost at lowest level (w/in relevant range)
Highest activity – Lowest activity

OR: Change in total costs / Change in activity level = Variable Cost per unit

Illustration 3. Assume the following:

Machine hours and electricity costs for ISU Industries for 2016 were as follows:

Month Machine Hours Utility Cost

January 2,500 P 36,800
February 2,900 42,000
March 1,900 27,000
April 3,100 46,000
May 3,800 56,500
June 3,300 44,000
Jul 4,100 49,500
August 3,500 45,500
September 2,000 31,000
October 3,700 52,000
November 4,700 62,000
December 4,200 P 55,500

Procedures:
1. Select the highest and lowest levels of activity and costs (within relevant range)

Machine Hours Utility Costs

Highest 4,700 P62,000
Lowest 1,900 27,000
Difference 2,800 35,000

2. Compute the variable cost per unit.

Variable Cost per unit = Change in costs / Change in machine hours
= P35,000 / 2,800
= P12.50 per machine hour

3. Compute the variable cost at the highest and lowest level of activity.
Highest level = 4,700 x 12.50 = P58,750
Lowest level = 1,900 x 12.50 = P23,750

4. Compute the fixed cost at the highest and lowest level of activity.
Highest level = 62,000 – 58,750 = P3,250
Lowest level = 27,000 – 23,750 = P3,250