" = : IPage CHAPTER TWO INTRODUCTION TO COST TERMS AND CLASSIFICATIONS Building upon your leanings of the first chapter, focusing on the introductory issues, we will now proceed your learning to the very important terminologies and concepts of cost. As a student of business, properly understanding and using these terminologies and concepts of cost is extremely important for you. Because, these are part of the language of cost and management accounting that are used in the day-to-day communication and operation of business organizations. So, let us start the chapter with question. Managers need to understand costs, Why? Though the financial results of companies are based on revenues and costs, companies usually have more control over their costs than they do over their revenues, In fact, one of the main goals of management accounting is controlling ing) costs, However, managers cannot control costs unless they understand cost |Accounting, as an information system, can be divided into three: Financial accounting, management accounting, and cost accounting. Financial accounting provides information to external users, It focuses on external reporting that is guided by generally accepted accounting principles, The information is primarily meant for extemal users such as suppliers, banks, customers, investors, taxing authorities, regulatory bodies, and so forth, Management accounting, on the other hand, measures and Teports financial information as well as other types of information that assists managers in fulfilling the goals of the organization. Managers rely on managerial accounting information to plan and control an organization's operations. Cost accounting reports financial and other information related to the organization's acquisition and ‘consumption of resources. It deals with the identification, accumulation, allocation, and control of costs, It provides the information for both management accounting and financial accounting. To manage an organization, systematic and comparative cost information as well as analytical cost and profit data are needed. This cost information helps management set the company's profit goals, establish departmental targets which direct middle operating management toward the achievement of the final goal, evaluate effectiveness of plans, pinpoint successes or failure in terms of specific responsibilities. and analyze and decide on adjustments and improvements to keep the entire organization moving forward, in balance, toward the established goals considered only as it applies to manufacturing operations. In today's type and size of organizations should benefit from the use of cost accounting concepts and techniques. For example, cost accounting principles may be applied by corDefinition of Costs ‘The word “cost” is usually used in our day to day conversation, It is a generic term that anyone needs to know. Cost is the amount of resource given up in exchange for some present and future benefits, ‘The resource given up i always expressed in terms of money. Cost plays a significant role in managerial functions such” as planning, controlling, decision-making, and directing operation activities. To guide decisions, managers want to know the cost of something, This ‘something’ may be a product, a service, a department, or any activity. We call this ‘something’ cost object and is defined as anything for which a separate measurement of cast is desired. Always activities consume resources and resources involve costs, Cost, Expense, and Loss Cost accounting involves the use of, the control of, and the planning of costs. The term cost differs from expense and loss, as seen by their definitions: 7 eA OM Berta taied mar ) posed eect st SER given up tis gc srs ests none rm yb ei pare of liabilities. weed |Loss! A cost that occ n goods d : ‘i ing “provided any benefit. This loss appears as a deduction from revenues. Expenses and losses both redice revenue, but are separately disclosed to highlight the loss.Different cost concepts and classifications are used for different purposes. Understanding these concepts and classifications enables the cost accountant to provide appropriate costs data to the ‘managers who need it. The purpose of the classification determines how the classification should be done. Cost data classified and recorded in a particular way for one purpose could be inappropriate for another use. For example, classification of costs for purposes of determining inventory valuations and cost of goods Sold for external reports differs from the classification of costs that would be carried ‘out to aid decision-making. It is important to note that the classifications of costs are not mutually exclusive. That is, a particular Cost may be classified in many different ways—depending upon the purpose of the classification, Cost accountants classify costs to meet the particular information need at hand. In Practice, the following classifications are used extensively. More than one may be used in any given circumstance. ‘You may encounter other classifications in practice. Cost classifications are needed for the development of cost data that will help (aid) management in achieving its objectives. @® These classifications are based on the following: Relationship of the cost tothe product. .. The department where the cost is incurree 1 ep TPage represent a major material cost of producing that product. products, They are the integral part of finished Indirect materials costs: - These are all materials used in the production of a product, that can not be casily and conveniently traced to the product, and that do not represent signfieant material cost of the product. It is difficult to determine such costs on a per unit basis as a result these will be considered as part of the factory overhead. II. LABOR: - is the physical and/or menial effort expended in the production of a product, Labor costs are divided into direct and indirect Direet labor cost: - It represents the cost of all labor actually involved in the production of a product, that can be easily and economically traced to the product in an economically feasible way and that represent a major labor cost of producing that product.” Feonomically feasible” means “cost effective rer the sense that managers do not want cost accounting to be too expensive in relation 10 expected benefits. It is the wage cost of employees working directly on the product as assemblers, machinists painters, welders, and some machine operators. Direct labor is sometimes referred to as “touch labor" since it consists of the costs of workers who “touch” the product as it is being made. Direct labor declining as a percentage of total manufacturing cost as automation increases in : facilities. Indireet labor eost: -It is cost of labor expended in the production p ‘be easily traced to the product and is part of the manufacturing ¢ cleial vor 11. FACTORY OVERE It consists of al] manufacturing costs other than direct materials and direct labor. lis an all-inclusive ost poo! used to accumulate all indireet manufacturing ests, which cannot be directly identified with Specific cost object. These costs cannot be easily and conveniently ‘traced to products. All inl Sees ‘and labor and many other costs including, depreciation on'manufactiing synonymous with indirect man Wwerheas r . arnt be related to individual products. FOH is sometimes called mansing (O14 include indirect materials cost, indirect labor cost, Examples of F mat heat, light and power, factory depreciation etc. ‘Therefore, the following equations hold true- Factory line supervisors r - Employee fringe benefits sl tikes Factory clerical workers “Reyrolltaxeg, |: - Timekeepers ~ Workers* compensation insurance i = Small too! ~ Factory superintendents - Factory utilities ~ Packaging materials ~ Janitors ~ Rent of factory buildi , Warehouse, cHtems used in small | - Receiving clerks and equipment eS ’ amounts in the | - Storeroom supervisors/clerks -Depreciation of factory building ‘man ing process - Purchasing employees &equipment -Idle-time costs of direct workers ~ Overtime premiums of direct workers. - Fire and casualty insurance 1. Cost objects can be: ice c)abrand category —_d) all of the above ee Renee ae to once achieve a specific objective. gta [v. Tre _b) False : 3. A cost object is always either a product ora service, < + b) False indirect materials are classified as facturing iIn manufacturing businesses departments can be classified into manufacturing t c ig (oF producing) and no1 ‘manufacturing (or service) departments. The manufacturing/non-manufacturing cost classification is ‘important in all cost accounting functions. ied. Le | act Manufacturing (Producing Department) Costs: afe costs incurred in departments that contribute directly to the production of the item and include costs of deparments in which conyersion and poe face. Non-Manufacturing (Service Department) # are costs incurred in departments which are. direct! to roduction of the ites wide services to other dey rents. The cost of maintenance, accounfing, health and other departments are considered as non-manufacturing or service department costs. ‘Costs can also be classified based on the functional areas of an organization. All ifa sturing ‘organization may be divided into manufacturing, marketing, administrative and general manager is an example. IRiranciag cox-inre cons related (esining fanis operate the company. Example is interest Vand ad Belet to fe ls Based on the relationship of the costs to the production process, we can classifyts may also be classified on the basis of the ti ir i charged ts may also time or accounting period they are to be . Some costs are first recorded as assets and then expensed as they aeuaetee are immediately expensed in the year of incurrence. Product costs and periodic costs are ‘according to this classification. WA Luts 8 -are costs disgeily and indirectly identifiable with the product. These costs provide no product is sold and are therefore inventor able, ic. it is part_of the are added to units Of product (i.e., "inventoried" as they are are not a ‘units are sold. This can result in a delay of one or more periods between the time ‘incurred and when it appears as an expense on the income statement. Product costs ‘known af inventoriable costs) “s eo Fe ee Ge cy op idly relied he eee nee ecpeatlaget Tevenue) immediately and are therefore non- jg lg. All selling and administrative costs are typically considered to be period costs. These costs are also called non-inventorable costs. Product. costs become period cost when products ate S0ld. (co iy ¢ Amante cor} Taking the response of a cost to changes in production volume as a base we can classify costs into variable, fixed. and mixed. ie Variable costs: are costs that change in direct proportion to changes in volume of output, whereas the Variable costs are easily traceable fo units of output controlled by _e Precise amount of varnish r at a house furniture factory, but it wouldn't be worth the effort, tae typically be considered an indirect material and would be included in overhead. n typically accounts for costs in two basic stages: as: Materials, labor, fuel, and factory overhead, + It assigns these costs to cost objects, Cost accumulation isthe collection of cost data in some organized way (such as ‘material, labor, fuel, ete) through accounting system. \compasses both tracing and allocating accumulated costs ig of direct costs to the chosen cost object, and cost the chosen cost object. Direct costs are costs that are direct costs are costs that are common to ‘two or more: that includes both: Cost assignment is the general term that en. to a cost object. Cost tracing is the assi allocation is the assigning of indirect costs to related to the particular cost object whereas in. ost objects. Cost assignment is a general term Tracing accumulated costs to a cost object.‘A1[Page _a) The materiality of the cost in question: For costs that are immaterial, tracing will not be cost effective (or not as such relevant) even ifthe cost ‘has direet relation with cost object. For example, glues and invoice papers sent with the product usually are classified as indirect (not traced) as they are immaterial b) Available information-gathering technology: Improvements in the information technology will make cost tracing simpler and more cost effective ‘and make more costs to be direct. ¢) The cost object selected: For example, consider the salary of supervisor in the maintenance department of a textile factory. If the cost object is the department, the supervisor's salary isa direct cost. In contrast, if the cost object is service (product), the supervisor's salary is an indirect cost. Thus, a particular cost may be simultaneously be direct and indirect, depending on the type of cost objective/object. 4) Design of operations: 1. Which of the following does NOT affect the direct/indirect classification of a cost? 4) the level of budgeted profit for the next year 'b) the materiality of the cost in question ‘c) available technology to gather information about the cost -d) the design of the operation 2. Which of the following statements about the direct/indirect cost classification is NOT true? a), Indirect costs are always traced. _b) Indirect costs are always allocated. The design of operations affects the direcVindirect classification.| AB Page we eons and Budgeted costs: fasts are those costs which should be incurred in a particular production process under Standard costing is usually concerned with per-unit costs of direct material, I, whereas budgeted costs usually provide forecasted activity on a total cost basis D. Opportunity Costs. An opportunity ‘cost is the potential benefit that is given up by selecting one alternative over another, ‘The concept of an opportunity cost is rather difficult for students to understand because it is not an a expenditure and it is rarely (if ever) shown on the accounting books of an organization. It is, >wever, a cost that must be considered in decisions. E. Sunk Cost. sunk cost is a cost that has already been incurred and that cannot be changed by any decision made ‘or in the future. Since sunk costs cannot be changed and therefore cannot be differential costs, ould be ignored in decision-making. While students usually intellectually accept the idea that | be ignored, they often have difficulty putting this idea into practice. A sunk cost is ‘that has been spent and it cannot be recovered. For example, if you are considering amount you paid for it two years ago is sunk. It should not influence the amount bh of a used car is set by the market. There is an | Shutdown costs: - are fixed costs that would be incurred even if there were no production. G. Committed Vs Discretionary costs. Committed costs are costs that will continue even if an organization shuts down for a short time. These costs cannot be eliminated without endangering an organization's overall health and existence. Examples are the cost of facilities and top management. Discretionary costs are costs that exist as the ‘management decision. In comparison with committed costs, such costs are more easily ‘bad economic times without doing serious long-run harm 10 the entity, Examples are a training program, an advertising campaign, and corporate contributions.Predict how costs will change in response to changes in activity. put of goods or services or it might be some measure of activity internal ‘purchase orders processed during a period. In this material, nearly all the activity is the output of goods or services. In later chapters, other classify costs according to how they react to changes in activity, in this : simple variable and fixed classifications. A variable cost is constant per unit | as the activity level rises and falls. A fixed cost is constant in total for inthe relevant range. (Just about any cost will change if there is a big enough Fixed costs do not change for changes in activity that fall within the "relevant ‘on a per unit basis, a fixed cost is inversely related to activity - the per unit 1 activity rises and inereases when activity falls. : controversy conceming the proper definition of the “relevant range." Some refer to relevant range as the range of activity within which the company usually operates. We refer to the relevant range as the range of activity within which the assumptions about variable and fixed costs are ‘valid, Either definition could be used - our choice was dictated by our desire to highlight the notion that fixed costs can change if there is a large enough change in activity. Understanding the behavior of variable and fixed costs is one of the most difficult parts of cost ‘accounting, To assist in this understanding, a summary of both variable and fixed cost behavior is presented below.Is its flow of operations. The steps in a typical cycle of its own products are outlined below. oa $ and supplies needed for manufacturing and ordered, received, and labor and services are obtained. 3 ransferred from the storeroom to the factory labor, tools, machines, r complete the product. ed from the factory to the warehouse to be held until they are dd from the warehouse an irement: Purchases of materials, labor, and overhead are recorded as debits to raw “Materials, factory payroll clearing and manufacturing overhead control. As these costs areAT|Page Procurement »| Production Warehousing +} Se materials Work-in-process Finished goods Cost of goods sold T ial | Income summary IN | OUT———— IN oor IN: IN ouT (Of the four steps in the operating cycle, production is probably the most complicated to account for and to control Recording Cost Flows ‘There are cight common transactions in a typical job order costing system. 1. When raw material are purchased: Raw materials...... 5 xxx Voucher payable..........1.000-« hype et: XXX, aax Risso 0 ‘overhead control... ax Raw materials. XOX 3. When factory wages are earned: Factory payroll clearing. Xxx Salaries and wages payable. Xxx 4, When labor is charged to operations: Work-in-process. Xxx Manufacturing overhead control XXX Factory payroll clearing Xxx 5. When other manufacturing overhead costs are incurred ‘Manufacturing overheads cost applied..........XXX Voucher payable and other accounts.........XXX 6. When factory overhead costs are transferred to work in process inventory account: Work-in-process........0.. XXX ‘Manufacturing overhead contro xxx When finished goods are transferred from factory tothe store‘which is concerned with precise recording and measurement of flow through the production processes. This flow is illustrated in * Work in process Inventory -DM -DL -FOH Expended (applied) toting systems refer to the processes, techniques, and methods employed in the ascertainment of ts. The costing system to be used in a particular concem depends up on the type of manufacturing nature of industry. The following are some of the costing systems that are used in practice. I. Job order costing-this system is used in those industries where work is done according to customer's specification. Examples of such industries are repair shop, printing press, etc. I. Process costing- this system is used in mass production industries where raw materials have to pass throug number of processes to completion. Moreover, the units are indistinguishable. Examples are textile, sugar, paper and comical industries. Contract costing- when a job is big and work is to be done at site, it is known as contract. Contract ‘costing is applicable in indusiries like building construction, bridge construction, ship building, etc. TV. Batch costing- like contract costing, it is also a variant of job order costing. In batch costing, productions of identical products are arranged in groups or batches and costs are ascertained for ‘each batch separately. This system is used in toys, ready made garments, tyres and tubes, etc. V. Output or unit or single costing- this costing system is employed when production is uniform and consists of a single product and its different grades. Examples are brick work, mining, etc. Vi. Multiplier or composite costing- use of more than one system of costing in the same product is ‘known as multiple costing. Examples are televisions, automobile, computers, and other assembly type of production.ABC Company Cost of Goods sold schedulene information appeared in the financial statements of ABC Company on 31° December eee ‘Cost of goods manufactured . $405,000 git Cost of direct materials used, 160,000: NG FOH, 80% of direct labor cost 92,000» ‘Work in process (endi - 48,000 Required: Compute: work in process on January 1, (at the beginning of the year) Assume all the data in Example 1 above and the following additional information for ABC Company. ‘Direct materials (bes $80,000), Direct materials purchased $270,000) 3 Finished Goods (F.G) available for sale and. 500,000. Finished goods inventory (ending). a $120,000 4 Required: - prepare the cost of goods sold schedule ' t24|Page ‘On June 30, 2012 flash Ptceotic pose damaged the warehouse and factory of XYZ Corporation, completely ne es non “There was no damage to either the materials or finished ds inventories. A physical inventory takenafterthe flood revealed the following valuations. ‘Direct materials Inventory.........-...... $4 WIP inventory 1.0.0. — Finished goods imsentory....-- - $45,000 jnventory on Jan T, 2012, consisted of the following: $184,000 80,000 50,000 profit margin historically approximated '§340,000, Direct materials purchases Sok and reconds disclosed thatthe gross has historically been tsales for the frst six months of 2012 were Gost for this period was $100,000; factory overhead value of the work in process lost a June 30,2012