Cost Terms,

Concepts, and
Classifications
Objectives
At the end of this lesson, the students will be
able to:
1. Distinguish between cost, expenses, and
losses
2. Familiarize with the different classification of
costs
3. Know how to compute in segregating mixed
costs into fixed cost and variable cost
Assignment
1. Why do managers consider direct
costs to be more accurate than indirect
costs?
2. How does cost, expense, and loss differ
from each other? Explain.
3. Explain the significance of relevant
range.
Definition of Terms
Cost
Cash or cash equivalent value sacrificed or
foregone for goods and services that are expected
to bring current or future benefit to the organization

Cost Object
any end to which cost is assigned, collected, or
accumulated. It is also anything for which a
measurement cost is desired.
This may be a product, service, project, customer ,
activity, or department
 Definition of Terms
Cost Pool
an aggregate of all the costs associated with
performing a particular business task
Cost we want to assign to the cost object or into
meaningful groups
May be classified by type of cost (DL, DM), By source
(Dept. 1, 2), By responsibility (Manager 1, 2)

Cost Accumulation
Collection of cost data in some organized means in
accounting system
 Definition of Terms
Cost Assignment
Designation of cost object to aid in decision making

a. Cost Tracing
Tracing accumulated costs that have a direct
relationship to a cost object
b. Cost Allocation
Allocating accumulated costs that have an indirect
relationship to a cost object
Definition of Terms
Cost Driver
It’s a variable which are those activities that has an
absolute cause-and-effect relationship to total cost.

Relevant Range
refers to the assumed range of activity that reflects
the company’s normal operating range. The cost
behaviors within this range are variable and fixed.
Cost vs. Expense
EXPENSE
is a cost charged against revenue in an accounting
period which we can observe in the income
statement.

COST
the resource given up or sacrificed regardless what
account we will record it whether asset or expense.
Some costs are recorded as an asset, initially, like
prepaid rent but eventually recorded as expense
through time. There are also cost that are not
recorded like opportunity cost.
Cost Behavior

It means how a cost will react as

changes take place in the level of
business activity
 Importance of
Understanding Cost Behavior
a) Planning – requires that management make
decisions based in part on expectations as to the
future (based on data)
b) Control – process of using feedback information for
comparison with expectations and the
implementation of actions on the basis of
comparison
Classifications of Costs
A. As to presentation in the Financial
Statements

1. Unexpired Costs
– balance sheet value of an asset
2. Expired Costs
– portion of an asset’s value consumed
shown in income statement as expense
 Classifications of Costs
B. As to relation to a product
(Product / Inventoriable Costs – BS)

1. Direct Materials
 materials that become part of the finished product
and can be conveniently and economically traced
to specific product units. Hence, direct cost

Indirect Materials, on the other hand, are those

materials that also becomes part of the finished
product but the cost of actually tracing it is too
expensive and its cost is relatively small.
 Classifications of Costs
B. As to relation to a product
(Product / Inventoriable Costs – BS)

2. Direct Labor
Refers to the amount paid as wages and salaries to
those individuals who manufacture a product or
perform a service.
These are the works that directly adds value to the
final product or service
Indirect Labor costs are those labor costs that
cannot be conveniently and economically traced
to end products.
Classifications of Costs
B. As to relation to a product
(Product / Inventoriable Costs – BS)

3. Factory Overhead
a catchall / dumping account for manufacturing
costs that cannot be classified as direct materials
or direct labor costs
any factory or production cost that is indirect to
manufacturing a product or providing a service.
Hence, includes indirect materials and indirect
labor costs
Classifications of Costs
Factors affecting direct or indirect classification
 Materiality of the cost in question
 Available information-gathering technology
 Design of operations
 Choice of cost object: generally the broader the
definition of the cost object, the higher the
proportion of total costs that are direct costs and
more confidence in cost accuracy
Classifications of Costs
Classifications of Costs
Classifications of Costs
C. As to relation to a product (Period Cost – I/S)

1. Marketing or Selling Expense

 All cost necessary to secure customer orders and get
the finished product or service into the hands of the
customer
 Often referred to as “order-getting” and “order-filling”
cost

2. Administrative Expenses
 All executive, organizational, and clerical expenses that
cannot logically be included under either production or
marketing.
Classifications of Costs
D. As to Cost Behavior

1. Variable Cost
a cost that varies in total proportionately with
activity but constant as to per unit
examples: direct materials, direct labor, royalties,
commissions of salesmen
Classifications of Costs
D. As to Cost Behavior

2. Fixed Cost
 A cost that remains constant in total within the
relevant range of activity, but inversely proportion
as to per unit
 Examples: salaries of production executives,
depreciation of equipment (Straight-line method),
periodic rent payments, and insurance
Classifications of Costs
Categories of Fixed Costs:

Committed
– cost that represent relatively long-term commitments on
the part of management as a result of past decision. E.g.
Depreciation

Managed (Discretionary, Programmed, Planned)

- cost that are incurred on a short-term basis and can be
more easily modified in response to changes in
management objectives. E.g. advertising, research and
development, cost of training employees
Classifications of Costs
Variable vs. Fixed
Illustration: Variable Cost
Activity Variable Cost per Unit Total Variable Cost
(A) (B) (A * B)

1 P100 P100
10 P100 P1,000
20 P100 P2,000
30 P100 P3,000

As the activity increases, TOTAL variable cost increase.

(direct proportional)

Variable Cost per UNIT – remain constant

Illustration: Fixed Cost
Activity Total Fixed Cost Fixed Cost per Unit
(A) (B) (B / A)
1 P1,500 P1,500
2 P1,500 P750
5 P1,500 P300
10 P1,500 P150
20 P1,500 P75
30 P1,500 P50

Whatever the activity level is, TOTAL fixed cost is CONSTANT.

As the activity level increases, Fixed Cost per UNIT decreases

(inverse proportional)
Classifications of Costs
D. As to Cost Behavior

3. Mixed Cost
Items of cost with both fixed and variable
components
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
Classifications of Costs
Types of Mixed Costs
Semi-variable
the fixed portion of which 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. Example: Cost of Electricity
Classifications of Costs
Semi-variable
 Assume that a company rents a delivery truck at a
flat rate of P20,000 per month plus P1.50/km. driven.
If 10,000 kms are driven for the month, how much is
the total monthly cost?

Flat Rate (fixed portion) P20,000

Variable Portion (10,000 * P1.50) 15,000
Total Cost P35,000
Classifications of Costs
Types of Mixed Costs
Step Cost
shifts upwards or downwards when activity
changes by a certain interval or “step”. A step
cost can be fixed or variable. Step variable
costs have small step; step fixed cost have large
steps.
Classifications of Costs
Step Cost
 Assume that one supervisor with a salary of
P30,000 is needed for every 10 workers.
Therefore, if there are 20 workers it should hire
2 supervisors with now P60,000 salaries. Also, if
there are 26 workers it should hire 3
supervisors with now P90,000 salaries
Classifications of Costs
E. As to association with cost object
1. Direct Costs
 Conveniently and economically traceable to the
cost object
 examples: SM Department Store – shirts, pants, etc.

2. Indirect Costs
 Cannot be economically traced to the cost object
 Example: SM Department Store – threads used to sew
the shirts
Classifications of Costs
F. As to nature (Common vs Joint)
1. Common Costs
 costs of facilities or services employed in two or more
accounting periods, operations, commodities, or services.
These costs are subject to allocation similar to indirect costs
 Example: Building Depreciation where the same building is
occupied by two departments and allocated based on floor
area occupied

2. Joint Costs
 cost of materials, labor, and overhead incurred in the
manufacture of two or more products at the same time.
Normally indivisible thus inherently difficult to allocate
 example: manufacturing costs to manufacture two or more
products
Classifications of Costs
F. As to relation to accounting period

1. Capital Expenditure
 Expenditure intended to benefit more than one
accounting period and recorded as an asset
 Example: Cost of PPE purchased

2. Revenue Expenditure
 Expenditure that will benefit current period only and is
recorded as an expense
 Example: advertising
Classifications of Costs
G. Cost for Planning, Control, and Analytical
Processes

1. Standard Cost
 Predetermined costs for direct materials, direct labor and
factory overhead.
 -Cost serve as benchmark in the budgetary control system

2. Opportunity Cost
 Benefit given up when one alternative is chosen over another
 not recorded in the accounting system
 can be used for decision making in evaluating alternatives
Classifications of Costs
G. Cost for Planning, Control, and Analytical
Processes

3. Relevant Cost
 Future cost that changes across alternatives.
 Common examples are cost of goods sold, advertising
expenses, commissions

4. Out-of-pocket Cost
 Cost that requires the payment of money (or other assets)
as a result of their incurrence
Classifications of Costs
G. Cost for Planning, Control, and Analytical
Processes

5. Sunk Cost
 Refers to money that has already been spent and which
cannot be recovered. These are excluded from future
business decisions because the cost will remain the
same regardless of the outcome of the decision.
Classifications of Costs
G. Cost for Planning, Control, and Analytical
Processes

6. Differential Cost
 Cost that is present under one alternative but is absent in
whole or in part under another alternative
 Incremental Cost: increase in cost from one alternative
 Decremental Cost: decrease in cost from one alternative
 Can be either fixed or variable
Classifications of Costs
Differential Cost
E.g. Avon Corp. is thinking about changing its
marketing method from distribution through
retailers to distribution by direct sale

Retailer Direct Sale Differential

(Present) (Proposed)
Revenue (V) P900,000 P1,200,000 P300,000
COGS (V) P450,000 P600,000 P150,000
Advertising (F) P80,000 P45,000 P(35,000)
Commission (V) - P40,000 P40,000
Warehouse Depn (F) P50,000 P80,000 P30,000
Other Expenses (F) P60,000 P60,000 -
Net Income P260,000 P375,000 P115,000
Classifications of Costs
H. As to Managerial Influence
1. Controllable
 If a particular level of management has a power to authorize
the cost
 Example: Entertainment expense is controllable by sales
manager

2. Non-controllable
 If a particular level of management has no power to authorize
the cost
 Example: Sales manager has no control for the depreciation
of warehouse facilities
Classifications of Costs
H. As to Managerial Influence

Special Case as to Time Dimension

- Costs that are controllable over the long run may not be
controllable over the short run
- Example: Advertising Expense where once signed has
no control over its period but when expired that is the time
it is controllable whether to be renewed or not
Classifications of Costs
I. As to quality control

1. Prevention Cost
 Those cost incurred to improve quality by precluding
product defects and improper processing from occurring
 Example: Training program, researching customer needs,
and acquiring improved production equipment

2. Appraisal Cost
 Amounts incurred for monitoring or inspecting
 Costs incurred to find mistakes not eliminated through
prevention
Classifications of Costs
I. As to quality control

3. Failure Cost
 Costs incurred for the inability to control quality results
which may be internal (e.g. scrap and rework) or
external (e.g. product return costs due to quality
problems, warranty costs, and complaint department
costs)
Illustrative Problem
Bettina Cabrera is the production manager of a
ready-to-wear manufacturing outfit. A decision
needs to be made about the type of clothing
material or fabric to be used to make a shirt. The
fabric that has been used in the previous
production cost P40 per yard but is not available
currently. Similar material from another supplier will
cost P50 per yard.
 Illustrative Problem
Cost Classification Explanation
Time Period Historical Cost – P40.00
Future Cost – P50.00
Management Function Cost of Fabric = Manufacturing Cost
Accounting Treatment Product Cost
Traceability to Product Direct Cost
Cost Behavior Variable Costs
Decision Significance P50.00 is relevant
P40.00 is irrelevant
Managerial Influence Controllable
Others Out-of-pocket cost until producing additional
skirts which will involve cash outlay in its acquisition
Separation of Mixed Costs
General Formula of Mixed Cost

Y = a + bX

Y = Total Mixed Cost (dependent variable)

a = Total Fixed Cost (vertical intercept)
b = variable cost per unit (slope of the line)
X = activity level/ cost driver (independent variable)
 COST ESTIMATION
Analysis of Mixed Costs
Fixed portion represents the basic, minimum cost of
just having a service ready and available for use,
while
Variable portion represents the cost incurred for the
actual consumption of the service

Basic idea of cost estimation is to estimate the

relation between costs and variables/factors
affecting the costs.
 COST ESTIMATION
Methods:
A. Account Analysis
B. Industrial Engineering Method or Work
Measurement Method
C. Conference Method
D. Quantitative Analysis of Current and Past Costs
Relationships
a) High-Low Method
b) Regression Analysis (Scattergraph & Least
Squares)
 A. Account Analysis
It makes use of the experience and judgment of
managers and accountants who are familiar with
company operations and the way costs react to
changes in activity. (subjective approach)

Steps:
1. Review each cost account used to record the
costs that are of interest
2. Major overhead/ mixed costs are itemized and
divided into its estimated fixed or variable costs
B. Industrial Engineering Method
It estimates cost functions by analyzing the
relationship between inputs and outputs in
physical forms.
Engineering estimates indicate what costs should
be.
Time-and-motion study is involved.
 C. Conference Method
Cost functions are estimated based on the
analysis and opinions about costs and their drivers
obtained from various departments of an
organization
Determines the selling price of the product,
optimum product mix, and evaluate cost
improvements over time
D.1. High-Low Method
Analyzes a mixed cost by first selecting the
highest and lowest levels of activity in a data set
if these two points are within the relevant range
Basis of Selection: Activity Levels or Cost Driver
since it causes cost to change
Outliers: disregarded in the analysis – these are
non-representative or abnormal observations
which happened outside the relevant range (e.g.
special rush order could require excess labor or
machine time) or cost distortions occur within the
relevant range (e.g. a leak in a water pipe goes
unnoticed for a period of time).
High-Low Method
General Formula / Steps:
High-Low Method
Illustration: BASIS

LOWEST

HIGHEST
High-Low Method
Illustration:
High-Low Method
Illustration:
Final Step is to arrive at the correct cost
formula based on High-Low Method:

Formula: Y = 397 + 7X
Method of Least Square
A statistical technique that analyzes the
relationship between independent (casual)
and dependent (effect) variables
Used to develop an equation that predicts an
unknown value of a dependent variable (cost)
from the known values of one or more
independents variable (activities that create
costs)
Method of Least Square
Formula
Method of Least Square
Illustration: (same info from High-Low Method)
Step 1: Calculate the totals of X, Y, XY, X2
Method of Least Square
Step 2: Substitute the values to E2 and E3
Method of Least Square
Step 3: Deduct E2 from E3

Step 4: Eliminate “a” from the equations to get “b”

b = 6.77
Method of Least Square
Step 5: Substitute the value of “b” to either E2 or E3
to get “a”

Using E2:
Method of Least Square
Step 6: Translate the formula to E1
Method of Least Square
Notes:
as much as possible round-off the result
to 2 decimal places only, unless
otherwise stated in the problems
In most cases, the amounts derived
using high-low point and method of
least square are not the same
-END-