CHAPTER TWO

INTRODUCTION TO COST TERMS AND COST CLASSIFICATIONS

Chapter Objectives:

After completing this chapter you should be able to:

 Define cost, cost objects, direct costs, and indirect costs.
 Explain the relationships of costs drivers, variable costs, and fixed costs.
 Define Cost accumulation, assignment and allocation.
 Identify each of the three categories of a manufacturing product’s cost.
 Prepare the basic operational statements and statement of Cost of Goods Sold.

Introduction
Various cost concept and terms are useful in many contexts, including decision making in all
areas of the value chain. They help managers decide such issues as, how much should we spend
for research and development? What is the effect of product design changes on manufacturing
costs? Should we replace some production assembly with a robot? Should we spend more of the
marketing budget on sales promotion coupons and less on advertising? Should we distribute
from a central warehouse or from regional warehouse?

2.1. Cost and Cost Terminology

Meaning of Cost: Accountants usually define cost as a resource sacrificed or forgone to achieve
a specific objective. Most peoples consider cost as monetary amounts (such as dollars, pounds,
Birr, yen) that must be paid to acquire goods and services. But the term cost does not have a
definite meaning and its scope is extremely broad and general.
 As per the Committee on cost concepts and Standards of American Accounting Association
cost is defined as “economic sacrifice incurred as a result of business decision to achieve a
specific objectives”.
 It can also be defined as the value of economic resources used for producing or doing the
thing to be costed.
 In simple terms it can be defined as “the price paid for something or Cost object”. To guide
their decisions, managers often want to know how much a certain thing (such as a new
product, a machine, a service or a process) costs.

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Cost object is anything for which a separate measurement of costs is desired.
Example: Activity or operation, Product or services, Project, Departments, and Program.
2.2. Cost accumulation and cost assignment
A costing system typically accounts for costs in two basic stages:
 It accumulates costs by some „natural‟ (often self-descriptive) classification such as
materials, labor, fuel, advertising or shipping.
 It assigns these costs to cost objects.
Cost accumulation is the collection of cost data in some organized way through an accounting
system.
Cost assignment is a general term that encompasses both the process of cost tracing and cost
allocation.
1. Tracing accumulated costs that have a direct relation with the cost object to a cost object.
Costs that are traced to a cost object are direct costs, and
2. Allocating accumulated costs to a cost object, and costs that are allocated to a cost object are
indirect costs.
Cost and Expense
The terms cost and expenses are often used interchangeably. But they are different. In that cost is
the amount of total outlays made to acquire the legal ownership title of the asset. Or it is the
monetary value of the total service that the business entity is going (expect) to derive from the
asset.

Whereas Expense is an expired cost resulted from a productive usage of an asset. It is the cost
which has been matched against revenue of a particular accounting period.

Loss is a reduction in firms‟ equity other than from withdrawals of capital for which no
compensating value has been received. It is an expired lost resulting from the decline in the
service potential of an asset that generated no benefit to the firm. Example: Obsolescence or
destruction of stock by fire.

Cost Centre and Cost Unit

As one means of controlling, in many manufacturing enterprises cost is ascertained by cost

centre or cost unit or by both.

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Cost Centre
 For the purpose of cost determination the whole organization is divided in to small parts
or sections. Each small section is treated as a cost centre
 Is a section of a business to which costs can be charged Eg. A department, a person (sales
man), equipment (machinery), etc
Cost Centers are of two types:
1) Personal - This consists of a person or a group of persons. Examples: a sales man, a machine
operator, etc.
2) Impersonal - which consist of a location or an item of equipment or group of these.
Examples: a sales area, a department, a machine, a delivery van, etc.

From the functional point of view cost centers can be the following types:

 Production - These are those cost centers where actual production work takes place. e.g.
Weaving dept. of textile factory, melting dept. of steel producing, Corn crushing shop in a
sugar mill
 Service - There are those cost centers which are ancillary to and render services to
production cost centers. e.g. Power house, store room, repair shops, canteen etc

Cost Unit

 Steps further than cost center and breaks up the cost in to smaller sub divisions.
 Helps in ascertaining the cost of saleable products or services eg. The cost per meter of
cloth in Textile Company, the cost per ton of sugar, etc. Thus the meter of cloth and the
ton of sugar denote the cost units
 In short cost unit is a unit measurement of cost.
 Cost units may be of two type:
 Units of production eg. A ton of steel, a meter of cable etc
 Units of service eg. Cinema seats, consulting hours, passengers‟ mile etc

2.3. Cost Driver

A cost driver (also called a cost generator or cost determinant) is a variable, such as the level of
activity or volume that causally affects costs over a given time span. An activity is an event, task,
or unit of work with a specified purpose, for example, designing products, setting up machines,

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or testing products. The level of activity or volume is a cost driver if there is a cause-and-effect
relationship between a change in the level of activity or volume and a change in the level of total
costs. For example, if product-design costs change with the number of parts in a product, the
number of parts is a cost driver of product-design costs. Similarly, miles driven are often a cost
driver of distribution costs.

The cost driver of a variable cost is the level of activity or volume whose change causes
proportionate changes in the variable cost. For example, the number of vehicles assembled is the
cost driver of the total cost of steering wheels. If setup workers are paid an hourly wage, the
number of setup hours is the cost driver of variable setup costs.

Costs that are fixed in the short run have no cost driver in the short run but may have a cost
driver in the long run. Consider the costs of testing, say, 0.1% of the color printers produced at a
Hewlett-Packard plant. These costs consist of equipment and staff costs of the testing department
that are difficult to change and, hence, are fixed in the short run with respect to changes in the
volume of production. In this case, volume of production is not a cost driver of testing costs in
the short run. In the long run, however, Hewlett- Packard will increase or decrease the testing
department‟s equipment and staff to the levels needed to support future production volumes. In
the long run, volume of production is a cost driver of testing costs. Costing systems that identify
the cost of each activity such as testing, design, or set up are called activity-based costing
systems.
Examples of cost drivers of business functions in the value chain

Business function Cost Drivers

Research and development  Number of research projects
 Labour hours on a project
 Technical complexity of projects

Design of products, services and processes  Number of products in design

 Number of parts per product
 Number of engineering hours

Production  Number of units produced

 Direct manufacturing labour costs
 Number of set-ups
 Number of engineering change orders

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Marketing  Number of advertisements run
 Number of sales personnel
 Sales

Distribution  Number of items distributed

 Number of customers
 Weight of items distributed

Customer service  Number of service calls

 Number of products serviced
 Hours spent servicing products

Relevant Range: The relevant range is the band of normal activity level or volume in which
there is a specific relationship between the level of activity or volume and the cost in question.
Costs are described as variable or fixed with respect to a particular relevant range.

2.4. General Classifications of Cost

The work of management focuses on planning, which includes setting objectives and outlining
how to attain these objectives; and which includes the steps taken to ensure that objectives are
realized. To carry out these planning and control responsibilities, managers need information
about the organization. This information often relates to the costs of the organization. Cost is the
resource that are forgone or sacrificed to drive on objective (to get same thing) or to achieve a
specific objective. Cost objective is anything that needs a separate measurement of costs.
In managerial accounting, the term cost is used in many different ways. The reason is that there
are many types of costs, and these costs are classified differently according to the immediate
needs of management.

Managers may want cost data to prepare external financial reports, to prepare planning budgets,
or to make decisions. Each different use of cost data demands a different classification and
definition of costs. For example, the preparation of external financial reports requires the use of
historical cost data, whereas decision making may require predictions about future costs
(historical vs future);

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 Purpose of Cost Classification
Preparing external financial
statements
Predicting cost behavior in response 
to changes in activity
Assigning costs to cost objects such 
as departments or products
Making decisions
Cost Classifications
 Product costs (inventoriablet cos)
 Direct materials
 Direct labor
 Manufacturing overhead
 Non-manufacturing costs (Period costs
(expensed))
 Selling costs
 Administrative costs
Variable cost (proportional to activity)
 Fixed cost (constant in total)
Direct cost (can be easily traced)
 Indirect cost (cannot be easily traced)
 Differential cost (differs between alternatives)
 Sunk cost (past cost not affected by a decision)
 Opportunity cost (forgone benefit)

All types of organizations incur costs governmental, not-for-profit, manufacturing, retail, and
service. Generally, the kinds of costs that are incurred and the way in which these costs are
classified depend on the type of organization. For this reason, we will consider in our discussion
the cost characteristics of a variety of organizations manufacturing, merchandising, and service.
Our initial focus in this chapter is on manufacturing companies, since their basic activities
include most of the activities found in other types of organizations. Manufacturing companies are
involved in acquiring raw materials, producing finished goods, marketing, distributing, billing,
and almost every other business activity. Therefore, an understanding of costs in a manufacturing
company can be very helpful in understanding costs in other types of organizations. There are
many classes of cost. Among that the major are:

1. Manufacturing Costs
Most manufacturing companies separate manufacturing costs into three broad categories: direct
materials, direct labor, and manufacturing overhead.

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 a. Direct Materials:
The materials that go into the final product are called raw materials. This term is somewhat
misleading, since it seems to imply unprocessed natural resources like wood pulp or iron ore.
Raw materials refer to any materials that are used in the final product; and the finished product
of one company can become the raw materials of another company.

For example, the plastics produced by Du Pont are a raw material used by Compaq Computer in
its personal computers. One study of 37 manufacturing industries found that materials costs
averaged about 55% of sales revenues.

Raw materials may include both direct and indirect materials. Direct materials are those
materials that become an integral part of the finished product and whose costs can be
conveniently traced to the finished product. Materials such as solder and glue are called indirect
materials

b. Direct Labor:
Direct labor consists of labor costs that can be easily (i.e., physically and conveniently) traced to
individual units of product. Direct labor is sometimes called touch labor, since direct labor
workers typically touch the product while it is being made. Examples of direct labor include
assembly-line workers, carpenters and electricians who install equipment.

Labor costs that cannot be physically traced to the creation of products, or that can be traced only
at great cost and inconvenience, are termed indirect labor. Just like indirect materials, indirect
labor is treated as part of manufacturing overhead. Indirect labor includes the labor costs of
janitors, supervisors, materials handlers, and night security guards. Although the efforts of these
workers are essential to production, it would be either impractical or impossible to accurately
trace their costs to specific units of product. Hence, such labor costs are treated as indirect labor.

Major shifts have taken place and continue to take place in the structure of labor costs in some
industries. Sophisticated automated equipment, run and maintained by skilled indirect workers, is
increasingly replacing direct labor. Indeed, direct labor averages only about 10% of sales
revenues in manufacturing. In some companies, direct labor has become such a minor element of
cost that it has disappeared altogether as a separate cost category. Nevertheless, the vast majority

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of manufacturing and service companies throughout the world continue to recognize direct labor
as a separate cost category.

c. Manufacturing Overhead:
The third element of manufacturing cost includes all costs of manufacturing except direct
materials and direct labor.

Manufacturing overhead includes items such as indirect materials; indirect labor; maintenance
and repairs on production equipment; and heat and light, property taxes, depreciation, and
insurance on manufacturing facilities. A company also incurs costs for heat and light, property
taxes, insurance, depreciation, and so forth, associated with its selling and administrative
functions, but these costs are not included as part of manufacturing overhead. Only those costs
associated with operating the factory are included in manufacturing overhead.
Across large numbers of manufacturing companies, manufacturing overhead averages about 16%
of sales revenues.

Various names are used for manufacturing overhead, such as indirect manufacturing cost,
factory overhead, and factory burden. All of these terms are synonyms for manufacturing
overhead. It includes overtime premium, fringe costs and idle time.

Overtime premium is the wage rate paid to workers (for both direct labor and indirect labor) in
excess of their straight-time wage rates. Overtime premium is usually considered to be a part of
indirect costs or overhead.

Idle time is wages paid for unproductive time caused by lack of orders, machine or computer
breakdowns, work delays, poor scheduling, and the like.
payroll fringe costs (for example, employer payments for employee benefits such as Social
Security, life insurance, health insurance, and pensions).

2. Commercial Expenses/Nonmanufacturing Costs/ periodic costs/ operating expenses/: -

are all cost that are not included in product costs. These costs are expense on the income
statement in the period in which they are incurred.

Fall in to two large classifications:

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 1. Marketing (distribution and selling) expense - begins where the manufacturing cost
ends. i.e when manufacturing is completed and the product is ready for sale. Example:
advertising, shipping, sales travel, sales commission, sales salaries, and cost of finished
goods warehouses.
2. General & Administration expenses – expenses incurred in directing and controlling the
organization. Examples are executives‟ salaries and legal expenses.

Product Costs versus Period Costs

In addition to classifying costs as manufacturing or nonmanufacturing costs, there are other ways
to look at costs. For instance, they can also be classified as either product costs or period costs.
To understand the difference between product costs and period costs, we must first discuss the
matching principle from financial accounting.

Generally, costs are recognized as expenses on the income statement in the period those benefits
from the cost. For example, if a company pays for liability insurance in advance for two years,
the entire amount is not considered an expense of the year in which the payment is made.
Instead, one-half of the cost would be recognized as an expense each year. The reason is that
both years not just the first year benefit from the insurance payment. An expensed portion of the
insurance payment is carried on the balance sheet as an asset called prepaid insurance.

The matching principle is based on the accrual concept that costs incurred to generate particular
revenue should be recognized as expenses in the same period that the revenue is recognized.
This means that if a cost is incurred to acquire or make something that will eventually be sold,
then the cost should be recognized as an expense only when the sale takes place that is, when the
benefit occurs. Such costs are called product costs.

A. Product Costs
For financial accounting purposes, product costs include all costs involved in acquiring or
making a product. In the case of manufactured goods, these costs consist of direct materials,
direct labor, and manufacturing overhead. Product costs “attach” to units of product as the goods
are purchased or manufactured and they remain attached as the goods go into inventory awaiting
sale. Product costs are initially assigned to an inventory account on the balance sheet. When the
goods are sold, the costs are released from inventory as expenses (typically called cost of goods

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sold) and matched against sales revenue. Since product costs are initially assigned to inventories,
they are also known as inventoriable costs.

While emphasizing the product costs are not necessarily treated as expenses in the period in
which they are incurred. Rather, as explained above, they are treated as expenses in the period in
which the related products are sold. This means that a product cost such as direct materials or
direct labor might be incurred during one period but not recorded as an expense until a following
period when the completed product is sold.

B. Period Costs
Period costs are all the costs that are not product costs. For example, sales commissions and the
rental costs of administrative offices are period costs. Period costs are not included as part of the
cost of either purchased or manufactured goods; instead, period costs are expensed on the
income statement in the period in which they are incurred using the usual rules of accrual
accounting. Keep in mind that the period in which a cost is incurred is not necessarily the period
in which cash changes hands. For example, as discussed earlier, the costs of liability insurance
are spread across the periods that benefit from the insurance regardless of the period in which the
insurance premium is paid.

As suggested above, all selling and administrative expenses are considered to be period costs.
Advertising, executive salaries, sales commissions, public relations, and other nonmanufacturing
costs discussed earlier are all examples of period costs.
They will appear on the income statement as expenses in the period in which they are incurred.

Prime Cost and Conversion Cost

Two more cost categories are often used in discussions of manufacturing costs prime cost and
conversion cost. These terms are quite easy to define. Prime cost is the sum of direct materials
cost and direct labor cost. Conversion cost is the sum of direct labor cost and manufacturing
overhead cost. The term conversion cost is used to describe direct labor and manufacturing
overhead because these costs are incurred to convert materials into the finished product.

Cost in relation to Volume of Production (behavior)

 Some costs change in sympathy with production level while other costs remain
unchanged.

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  Based on their behavior or variability, costs are classified into Fixed, Variable and Semi-
Variable costs.

Fixed Costs: Costs that do not increase or decrease when the volume of production changes
rather it remain constant in „total‟ amount over a wide range of activities for a specified period of
time.
Eg. Building rent, managerial salaries etc

 But fixed cost per unit decrease when volume of production increases and vice versa.
 Fixed costs have the following characteristics
a) Fixed total amount with in a relevant output range /normal operating range/
b) Increase or decrease in per unit fixed cost when quantity of production changes
c) Apportioned to departments arbitrary
d) Controlled mostly by top level management

Fixed cost can be further classified as:

Committed – are those costs that are incurred in maintaining physical facilities & managerial
setup. Once the decision to incur them has been made, they are unavoidable invariant in the
short run.

Example:
 Salary of managing director may represent a committed cost if, by policy, the managing
director is not to be relieved unless the firm is liquidated.
 Depreciation of equipment and plant is committed because these facilities cannot be
easily changed in the short run.
Discretionary- are those costs which can be avoided by management decision e.g. advertising,
research & development, salaries of low level managers, etc., because these cost may be avoided
or reduced in the short run.

Variable Cost

 Cost that tend to vary in direct proportion to the volume of production

 When volume of output increases, total variable costs also increase and vice versa
 But the variable cost per unit remain fixed
 Variable costs have the following characteristics

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 a) Variability of the total amount is direct proportion to volume of output
b) Fixed per unit
c) Assigned accurately to departments at reasonable ease
d) Controlled by functional managers

Note: Costs are defined as variable or fixed with respect to a specific cost object and for a given
time period.

Semi Variable (Mixed) Costs: Costs that vary with changes in volume but, unlike variable
costs, do not vary in direct proportion. In other words, these costs contain both a variable
component and a fixed component. i.e. an amount that is fixed with in a relevant range of output
and an amount that varies proportionately with output. Examples are the rental of a delivery
truck, for which a fixed rental fee plus variable charge based on mileage is made; and power
costs, for which the expense consists of a fixed amount plus a variable charge based on
consumption.

2.5 Reporting the Results of operations

The Balance Sheet
The balance sheet or statement of financial position, of a manufacturing company is similar to
that of a merchandising company. However, their inventory accounts differ. A merchandising
company has only one class of inventory goods purchased from suppliers for resale to customers.
In contrast, manufacturing companies have three classes of inventories. That is raw materials,
work in process, and finished goods.
1. Raw materials are the materials that are used to make a product.
2. Work in process consists of units of product that are only partially complete and will
require further work before they are ready for sale to a customer.
3. Finished goods consist of completed units of product that have not yet been sold to
customers.
Ordinarily, the sum total of these three categories of inventories is the only amount shown on the
balance sheet in external reports. However, the footnotes to the financial statements often
provide more detail.

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Income statement
XYZ Manufactured Company
Income Statement
For the year ended Dec.31, xx
Revenue $xxx
Cost of goods sold:
Beginning merchandise sold Xxx
Add: purchase Xxx
Goods available for sale Xxx
Deduct: Ending merchandise Xxx Xxx
inventory
Gross margin Xxx
Selling and administrative
expenses:
Selling expense Xxx
Administrative expense Xxx Xxx
Net operating income Xxx

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 XYZ Company
Schedule of Cost of Goods Manufactured
For the year ended Dec.31, x1
Direct material
Beginning inventory $xxx
Purchase of direct material Xxx
Cost of direct material available for use Xxx
Ending inventory Xxx
Direct material used Xxx
Direct manufacturing labor Xxx
Indirect manufacturing costs
Indirect manufacturing labor Xxx
Supplies Xxx
Heat, light and power Xxx
Depreciation-plant building Xxx
Depreciation-plant equipment Xxx
Miscellaneous Xxx
Manufacturing costs incurred during the year Xxx
Add beginning work in progress inventory Xxx
Total manufacturing costs to account for xxx
Deduct ending work in process inventory xxx
Cost of Goods manufactured $xxx

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