Mindanao State University
College of Business Administration and Accountancy
DEPARTMENT OF ACCOUNTANCY
Marawi City
COST CONCEPTS AND CLASSIFICATIONS
Accounting 142
MEANING OF COST AND ITS USES
One objective of management accounting is to determine
the cost of products, services, customers and any other
items of interest to managers. In understanding costs and as
to how it can be used by management, the following terms
and concepts are relevant:
A. Cost – foregoing or potential expenditures (any
form of current or future cash outlay) measured in
monetary terms to achieve a specific objective; a
sacrifice required to attain a given objective.
B. Expenses – measured outflow of goods and
services that are matched against revenues to
determine income; an expired cost.
C. Loss – a form of expired cost that is not beneficial
to revenue producing activities of the enterprise;
no benefits were derived from this particular cost.
D. Cost object – anything for which cost is computed
such as a customer, product, a product line or a
segment of an organization.
E. Cost driver – any variable such as a level of activity
or volume that usually affects costs over a period of
time.
F. Activity – an event, action, transaction, task or unit
of work with a specified purpose. Activities can be
classified into:
▪ Value adding activities – activities that are
necessary or non-eliminable to produce the
products such as assembling the different
component parts of the product.
▪ Non-value adding activities – activities that
do not make the product or service more
valuable to customer such as moving the
materials and equipment parts from/to
stockroom or a workstation.
G. Value chain – a set of activities that a firm
operating in a specific industry performs in order to
deliver a valuable product or service for the
organization’s customers.
▪ Research and development – experimenting
to reduce costs or improve quality.
▪ Design – developing alternative product,
service or process designs.
▪ Supply – managing raw materials received
from vendors to reduce costs and improve
quality.
▪ Production – acquiring and assembling
resources to produce a product or render a
service.
▪ Marketing – promoting a product or service to
current and prospective customers.
▪ Distribution – delivering a product or service to
a customer.
▪ Customer service – supporting customers after
the sale of a product or service.
H. Cost pool – a grouping of individual cost items; an
account in which a variety of similar costs are
accumulated such as work in process and factory
overhead control accounts.
CLASSIFICATIONS OF COSTS
Costs can be classified in a number of ways depending on
the purpose of the classification. Such classifications of
costs are not mutually exclusive.
A. Classification as to function:
▪ Manufacturing costs – production costs of
factory related activities or those that are
incurred to transform materials to finished
goods.
a. Direct manufacturing cost – those that
are easily traceable to specific units of
production such as direct labor and
direct materials.
b. Indirect manufacturing cost – those
collection of product costs cannot be
practically or conveniently traced to
end products such as factory
overhead.
▪ Non-manufacturing costs – the operating
expenses of the business or those costs not
incurred in transforming materials to finished
goods.
a. Marketing expenses – distribution
expense or selling expensesor those
that covers the expenses of making
sales and delivery of products sold.
b. Administrative expenses – expenses
incurred in the direction, control and
administration of the organization.
c. Research and development – incurred
in designing and bringing new products
to the market.
d. After-sales costs – costs incurred in
dealing with customers after sales such
as warranty and repair costs.
B. Classification as to applicability to accounting
periods:
▪ Capital expenditures – outlays classified first as
an asset before being recognized as expense.
▪ Revenue expenditures – outlays classified
directly as an expense.
▪ Product cost – cost included in the calculation
of inventory costs; also known as inventoriable
costs.
▪ Period cost – costs charged against current
period operations and treated as expense
immediately.
C. Classification according to managerial influence:
▪ Controllable cost – cost that is subject to
influence by a particular manager within the
time period under consideration.
▪ Non-controllable cost – cost which a
manager does not have a significant
influence over.
D. Classification for planning, control and decision
making purposes:
▪ Standard cost – costs pegged at a
predetermined rate usually expressed on a
per unit basis; in total, it is the cost that “should
have been incurred” for actual production.
▪ Budgeted cost – future costs usually expressed
in totals; in total, the cost represents the
“should be incurred” for budgeted
production.
▪ Relevant costs – future costs that will differ
under alternative courses of actions.
▪ Irrelevant cost – costs that will not affect the
decision making process, thus, is ignored in
the analysis.
▪ Differential cost – difference in cost between
any two alternative courses of action.
a. Incremental costs – increase in cost
from one alternative to the other.
b. Decremental costs – decrease in cost
from one alternative to the other.
Page|1 of 5
 ▪ Marginal cost – additional costs expressed on
a per unit basis.
▪ Postponable costs – costs that may be
deferred or shifted to a future date or period
of time without adversely affecting current
operations.
▪ Avoidable cost – cost that can be eliminated
in whole or in part when one alternative is
chosen over another in a decision making
case.
▪ Unavoidable cost – costs that remain
regardless of what decision or alternative is
chosen.
▪ Out of pocket cost – cost that require current
or future cash outlay.
▪ Opportunity cost – cost of benefits foregone
as the result of the acceptance of an
alternative. It is measured as the benefits that
would result from the next best alternative use
of the same resources that were rejected in
favor of the one accepted.
▪ Imputed cost – hypothetical cost representing
the usage value of a particular resource.
▪ Sunk or past or historical cost – cost which are
already incurred and therefore irrelevant in
decision making process.
E. Classification in relation to a cost object:
▪ Direct cost – costs that are related to a
particular cost object and can be
economically and effectively be traced to
that cost object.
▪ Indirect costs – cost that are related to a cost
object but cannot practically, economically
and effectively be traced to such cost object.
Factors affecting the direct-indirect cost
classification follow:
a. Materiality of the cost in question.
b. Design of operations.
c. Availability of an information-gathering
technology.
d. Choice of cost object.
▪ Common cost – cost that benefit more than
one activity or department.
▪ Joint cost – apply to situations where multiple
outputs are derived from one source.
F. Classification as to the tendency to vary with
volume or activity:
▪ Variable cost – within the relevant range and
time period under consideration, the total
amount varies directly to the change in
activity level or cost driver and the per unit
amount is constant.
▪ Fixed cost – within the relevant range and
time period under consideration, the total
amount remains unchanged and the per unit
amount varies inversely or indirectly with the
change in the cost driver.
a. Committed fixed cost – cost that is an
inevitable consequence of a previous
commitment; costs to which
management is “stuck” with over an
extended period of time such as
depreciation and long-term lease
contract.
b. Programmed or discretionary or
managed costs – cost for which the
size or the time of incurrence is a
matter of choice of management
such as advertising costs and research
and development costs.
▪ Mixed cost – this cost has both a variable and
a fixed component.
▪ Step cost – when activity changes, a step cost
shifts upward or downward by a certain
interval or step.
a. Step variable cost – a step cost that
have smaller steps.
b. Step fixed cost – a step cost that have
larger steps.
▪ Non-linear cost – total cost increases but per
unit decreases as activity increases.
To analyze curvilinear costs is to determine the
relevant range represented by the straight-
line in the graph.
COST BEHAVIOR ASSUMPTIONS
In management accounting, cost behavior refers to the
way in which costs are affected by fluctuations in the cost
driver, i.e. level of activity. An understanding of cost
behavior patterns is essential for many management tasks,
particularly in the areas of planning, decision-making and
control. It would be impossible for managers to forecast
and control costs without at least a basic knowledge of the
way in which costs behave in relation to the cost driver.
Economists correctly point out that many costs that
accountants classify as variable costs actually behave in a
curvilinear fashion. Nonetheless, within a narrow band of
activity, a curvilinear cost can be satisfactorily
approximated by a straight line. In determining cost
behavior, certain assumptions are assumed by the
accountant:
A. Relevant range – the band or level of activity where
the cost concepts and the relationship of variable
and fixed costs are considered valid. In the relevant
range, the following holds true:
Total Amount Per Cost Driver
Variable cost Variable Constant
Fixed cost Constant Variable
B. Linearity assumption – within the relevant range,
there is a strict linear relationship between the cost
and cost driver. Costs may therefore be shown as
straight lines.
Page|2 of 5
 C. Time assumption – the cost behavior patterns
identified are true only over a specified period of
time. Beyond this, the cost may show a different
behavior pattern.
Accountants should also be aware that a cost that is
considered variable in one organization may be
considered fixed in another due, for example, to differing
employment policies.
DETERMINING THE COST FUNCTION FOR MIXED COSTS
Mixed costs have variable and fixed cost components,
thus:
Total cost (TC) = Fixed cost (FxC) + Variable Cost (VC)
Total variable cost varies directly with the activity level or
cost driver, thus:
Variable cost (VC) = Variable cost per cost driver (b) x Cost
driver (x)
E. Backflush costing – this is a streamlined cost
accounting method that simplifies, speeds up and
reduces accounting effort or procedures in
accumulating product costs. Unlike in the traditional
job order and process costing systems, backflush
costing eliminates the detailed tracking of the cost
of work in process.
F. Activity-based costing system – this costing system
uses multiple drivers to predict and allocate costs
to products and services.
FLOW OF COSTS IN A FIRM
Cost flow refers to the manner in which costs move through
a firm specifically in its accounts and how such costs affect
the firm’s statement of financial position and income
statement.
Merchandising Firm

Since total cost is linearly related to the activity level or cost Purchases P xxx
driver, the cost function may be expressed as: Freight or transportation in P xxx
Total P xxx
Y = a + bx Purchase discounts (xxx)
where: Y – is the total cost; a – is the total fixed cost; b – Purchase returns and allowances (xxx)
variable cost per cost driver; x – activity level or cost driver. Net purchases P xxx
Needless to say, purely fixed costs may be expressed as Y =
a and purely variable costs as Y = bx. Merchandise inventory, beginning P xxx
Net purchases P xxx
COST ACCOUNTING AND COST ACCOUNTING SYSTEMS Total goods available for sale P xxx
Cost accounting is that part of the accounting system that Merchandise inventory, ending (xxx)
measures costs for decision-making and financial reporting
Cost of goods sold P xxx
purposes. It involves the two processes namely:
Sales P xxx
A. Cost accumulation – involves collection of cost
Cost of sales (xxx)
data in some organized means in an accounting
Gross profit P xxx
system.
Operating expenses (xxx)
B. Cost assignment – involves tracing and allocating
Operating income P xxx
accumulated costs to cost objects.
Other income P xxx
Examples of cost accounting systems commonly used by Other expenses (xxx)
businesses include: Income before tax P xxx
A. Job order costing – this product costing system is Income tax (xxx)
used by firms that provide limited quantities of Net income P xxx
products or services unique to a customer’s needs
Manufacturing Firm
or specifications. Costs are assigned or traced to
individual products. For a manufacturing firm, the cost of goods sold is
computed differently as the goods purchased are not sold
Examples: automobile repair shops and
as is but rather transformed first before being sold to
tailoring/dressmaking business.
customers.
B. Process costing – this system is used by firms that
produce many units of a single product or nearly Raw materials inventory, beginning P xxx
identical products for long periods at a time. Net purchases P xxx
Examples: soft drinks company and toy Total raw materials available for use P xxx
manufacturers. Raw materials inventory, ending (xxx)
Direct materials used P xxx
C. Hybrid product-costing system – this costing system
Direct labor P xxx
incorporate features from two or more alternative
Manufacturing overhead P xxx
product costing systems such as job order and
Total manufacturing costs P xxx
process costing.
Work in process, beginning P xxx
Examples: clothing and food processing
Total costs placed into production P xxx
operations.
Work in process, ending (xxx)
D. Standard costing – this method uses predetermined Total cost of goods manufactured P xxx
factors to compute the standard cost of materials, Finished goods, beginning P xxx
labor and factory overhead so that such costs may Total goods available for sale P xxx
be assigned to the various inventory accounts and Finished goods, ending (xxx)
cost of goods sold and can be used with the other
Cost of goods sold P xxx
cost accounting systems.

ILLUSTRATIVE PROBLEMS

PROBLEM 1: Classify the following selected costs below as _____ _____ _____ 4. Electrical costs of P20 per machine
variable (V) or fixed (F) cost, product (P) or period (E) cost hour are incurred in the factory in
and direct (D) or indirect (I) cost in relation to units or the manufacture of tables. Four
product. machine hours is needed to
manufacture one table.
_____ _____ _____ 1. Wood is used in the manufacture of _____ _____ _____ 5. The depreciation cost of the
tables at a cost of P100 per table. machines used in the manufacture
_____ _____ _____ 2. The tables are assembled by workers of the tables is P40,000 a year.
at a cost of P40 per table. _____ _____ _____ 6. The salary of the president of the
_____ _____ _____ 3. Workers assembling the tables are company is P100,000 a month.
supervised by a factory supervisor _____ _____ _____ 7. The company spends P250,000 per
who is paid P25,000 per month. year to advertise its products.

Page|3 of 5
_____ _____ _____ 8. Salespersons are paid a commission B. The cost of including one extra child in a day-care
of P300 for each table sold. center.
_____ _____ _____ 9. Rent paid for the factory building is C. The cost of merchandise inventory purchased five
P20,000 a month. years ago. The goods are now obsolete.
_____ _____ _____ 10. Insurance premiums paid for the D. The management of a high-rise office building uses
general office is P15,000 a year. 3,000 square feet of space in the building for its
own administrative functions. This space could be
PROBLEM 2: Classify the following fixed costs as normally
rented for P30,000. What economic term describes
being either committed (C) or discretionary (D).
this P30,000 of lost rental revenue?
______1. Depreciation of buildings used in manufacturing E. The cost of building an automated assembly line in
operations. a factory is P700,000. A manually operated
______2. Planned expenditures for research and assembly line would cost P250,000. What economic
development. term is used to describe the P450,000 variation
______3. Lease or rent of equipment on a long-term basis. between these two amounts?
F. Refer to the preceding question and assume that
______4. Payments of pensions to the retirees of the firm.
the firm is currently building the assembly line for
______5. Budgeted costs for management training and P700,000. What economic term is used to describe
development. the P700,000 construction cost?
PROBLEM 3: For items 1 to 9 that follow, draw a graph that PROBLEM 6: Following are costs incurred by Deadwood
best represents the cost behavior pattern described. Manufacturing Corporation during the previous month:
1. Straight-line depreciation on machineries and Direct materials P 100,000
equipment. Indirect materials (sand papers, lubricants,
2. The cost of chartering a private airplane. The cost is nails, rivets, paint and similar items) 5,000
P800 per hour for the first 6 hours of a flight; it then Direct labor 50,000
drops to P600 per hour. Indirect labor (salary of plant supervisor
3. The wages of table service personnel in a restaurant. and similar items) 10,000
The employees are part-time workers who can be Factory light, heat, water and electricity 4,000
called upon for as little as 4 hours at a time. Advertising and selling costs 6,000
4. Weekly wages of store clerks who work 40 hours each Sales commissions of agents 5,000
week. One clerk is hired for every 125 sales made Depreciation on administration building 3,000
during the month. Salaries of administrative personnel 20,000
5. The cost of tires used in the production of trucks. Depreciation on delivery equipment 3,000
6. Outbound shipping charges that increase at a Depreciation of plant equipment 2,000
decreasing rate as sales rise because the firm can Insurance on administration building 2,500
use more efficient modes of transportation. Depreciation of plant buildings 15,000
Gradually, however, at high levels of sales, freight Property taxes on plant buildings 4,000
costs start to increase at an increasing rate, which Insurance on plant buildings 2,500
reflects more transactions made to customers in far-
Requirements:
away locations.
7. Equipment leasing costs that are computed at P2 per 1. Compute for Deadwood’s total product costs and
machine hour worked. The company pays a total period costs for the current month.
maximum of P120,000 per month. 2. Compute for Deadwood’s total conversion costs for
8. The monthly cost of a franchise fee for a fast-food the current month.
restaurant. The franchisee must pay P20,000 plus 5%
PROBLEM 7: The following selected costs were extracted
of gross dollar sales.
from the accounting records of Los Angeles Machining:
9. The cost of electricity during peak demand periods,
A. Direct materials used in production.
which is based on the following schedule: up to
B. Wages of machine operators.
20,000 kilowatt hours – P4,000; above 20,000 kilowatt
C. Factory utilities.
hours – P4,000 + P0.02 per kilowatt hours.
D. Uncollectible accounts expense.
PROBLEM 4: Walnut Corporation operates a small medical E. Sales commissions.
lab in Kansas, one that conducts minor medical F. Salary of Los Angeles Machining's president.
procedures, including blood tests and x-rays for a number G. Factory depreciation.
of doctors. The lab consumes various medical supplies and H. Wages of plant security guards.
is staffed by two technicians, both of whom are paid a I. Machine lubricant used in production.
monthly salary. In addition, there is an on-site office Identify the costs that would be used to calculate (a) cost
manager who is also paid by the month. of goods manufactured (b) manufacturing overhead, (c)
Requirements: total period costs, (d) total conversion costs, (e) total direct
costs of the credit and collections department and (f)
1. If the lab's patient count increases by, say, 15%, will inventory valuation.
the lab's total operating costs increase by 15%?
Explain. PROBLEM 8: Data about Cisco Company’s production and
2. Walnut is considering opening an additional lab in a inventories for the month of June are as follows:
new suburban medical building. What will likely Purchases of direct materials P 143,440
happen to the lab's level of fixed cost incurrence? Freight in 5,000
Why? Purchase returns and allowances 2,440
Direct labor 175,000
PROBLEM 5: The following terms are used to describe various
Actual factory overhead 120,000
economic characteristics of costs:
Inventories:
Opportunity cost Differential cost
Finished goods, June 1 68,000
Sunk cost Out of pocket cost
Finished goods, June 30 56,000
Marginal cost Average cost
Work in process, June 1 110,000
Choose one of the preceding terms to characterize each
Work in process, June 30 135,000
of the amounts described below. Each term may be used
Raw materials, June 1 52,000
only once.
Raw materials, June 30 44,000
A. The cost of feeding 300 children in a public school
cafeteria is P450 per day or P1.50 per child per day. Cisco Company applies factory overhead to production at
What economic term describes this P1.50 cost? 80% of direct labor cost. Over or underapplied overhead is

Page|4 of 5
closed to cost of goods sold at year-end. The company’s Direct manufacturing labor 30.00
accounting period is on a calendar year basis. Variable manufacturing overhead 60.00
Requirements: Fixed manufacturing overhead 40.00
1. What was the amount of over or underapplied Requirements:
factory overhead for the month of June? 1. What is the total cost of producing 1,000 axles, 1,500
2. Prepare in good form a cost of goods sold statement axles and 2,000 axles respectively?
for Cisco for the month of June. 2. What is the per unit cost when producing 1,000 axles,
PROBLEM 9: Mighty Muffler, Inc., operates an automobile 1,500 axles and 2,000 axles respectively?
service facility. The table below shows the cost incurred PROBLEM 11: The Morton Company recorded the following
during a month when 600 mufflers were replaced. transactions for February 2011:
Number of Muffler Replacements
Raw Work in Finished
500 600 700 Materials Process Goods
Total costs: Purchases P 100,000
Fixed costs A P 8,400 J Beginning inventory 18,000 P 8,000 ?
Variable costs B 6,000 K Ending inventory ? 20,000 P 30,000
Total C P14,400 L Direct materials used 90,000
Direct labor ?
Cost per muffler replacement:
Manufacturing overhead 115,000
Fixed cost D G M (inclusive of indirect
Variable cost E H N materials used of
Total F I O P10,000)
Fill in the missing amounts, labeled A through O, in the Transferred to finished
table. goods ?
Cost of goods sold ?
PROBLEM 10: Axle and Wheel Manufacturing currently Sales were P560,000, with sales prices determined by
produces 1,000 axles per month, though its plant has a adding a 40% markup to the firm's manufacturing cost. The
capacity of 2,000 axles per month. The following per unit total cost of direct materials used, direct labor, and
data apply for sales to regular customers: manufacturing overhead during the month was P285,000.
Direct materials P 200.00 Calculate the missing values in the records above.

Page|5 of 5