Chapter Two

Cost Terms and Classifications

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What is a Cost?
 Is a sacrificed resource
 Can be an asset or an expense depending upon
whether the cost has future economic benefits or not

 Asset : is a resource that is expected to provide

future economic benefits (not used up)
 Thus cost is asset if its incurred for future benefit.
 Expense: A resource that is not expected to provide
future economic benefits (used up)
 Thus cost incurred for the past benefit is expense.
 Cost Terminology
 Cost object
 Any product, project, customer, department,
activity or service for which a company wants to
determine its cost
 Cost driver
 An activity that causes a cost to change
• Actual cost – a cost that has occurred
• Budgeted cost – a predicted /planned cost

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 Cost Terminology
• Cost accumulation/cost pool – a collection of cost
data in an organized manner to be allocated to cost
objects
• Cost assignment – is the general term that
encompasses both tracing and allocating accumulated
costs to a cost object
– Cost tracing: is the assignment of direct cost to the
chosen cost object.
– Cost allocation: is the assignment of indirect costs to
the chosen cost object
 2.1 Classification of costs
• Different cost concepts and classifications are used for
different purposes.
• Understanding these 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.

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 2.1 Classification of costs
• 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:
1. Relationship of the cost to the product.
2. The department where the cost is incurred.
3. Relationship of the cost to the production process.
4. The period to which the cost is charged to income.
5. Relationship of the cost to volume of production.
6. The ability to be traced
7. Relationship of cost to planning, controlling, and decision
making.
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1. Based on Relationship of the cost to the product

• Based on the relation ship of costs to the product, costs

can be classified as:
a. Direct Material costs ,
b. Direct Labor costs , and
c. Overhead costs.

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Direct materials cost:
Direct materials :
– are material that become an integral part of finished products.
– They are physically traced to the product
– Example:
• the direct materials for a baker include flour, eggs,
yeast, sugar, oil, and water
• Direct material for furniture is timber , steel
Direct material costs
 are all the costs of acquiring these materials which include:
– Invoice price to buy materials
– Less cash discount
– Plus non refundable taxes
– Plus freight-in
• Are cost that can be easily and economically traced to the 8
 Direct Labor cost
Direct labor:
• Are employees that convert the direct material in to a
product
• Direct labor is sometimes referred to as "touch labor"
since it consists of workers who "touch" the product as it
is being made.
• Example: assemblers, machinists, painters, welders
Direct labor cost:
• It represents the wage/salary paid to direct labors
• This cost is easily and economically traced to the product in
an economically feasible way

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Manufacturing Overhead Cost
• It consists of all manufacturing costs other than direct
materials and direct labor.
• These costs cannot be easily and conveniently traced to
products
• Are
a. Indirect material
b. Indirect labor and
c. Other manufacturing overhead cost

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 Manufacturing Overhead
Are costs that cannot be efficiently traced directly to specific
units produced, but are costs of production
• Factory supplies
• Oil, lubricants, blades
Indirect materials • Glue, staples
• Packaging materials
• Small tools
• Janitor labor
• Production supervisor
• Timekeepers
• Factory clerical workers
Indirect labor • Overtime premiums of direct workers

• Factory equipment depreciation

• Factory insurance
Other Factory overhead • Factory rent and utilities
•
costs Factory Property taxes
• Factory Repairs and maintenance
 2. Based on department where cost is incurred
• In manufacturing businesses departments can be classified into
manufacturing (or producing) and non-manufacturing (or service)
departments
Producing department/manufacturing cost costs:
• Production department is where conversion and production process
takes place
• costs incurred in this department are called manufacturing cost
• They also are DMC, DLC and FOHC
Service department/non manufacturing costs:
• Service departments are those that provide support service to
manufacturing department
• They are administrative and marketing departments
• Costs incurred in these departments are non-manufacturing or service
department costs.
• Treated as operating expense when incurred. 12
3.Based on Relationship of the cost to the production
process
• Based on the relationship of the costs to the production process, we
can classify costs into prime costs and conversion costs.
Prime costs
– are costs which are directly related to the production of a product.
– Prime cost is the sum of direct material costs and direct labor
costs.
Conversion costs
• are costs concerned with transforming direct materials into finished
products.
• are the sum of direct labor and factory overhead costs.
• Prime cost = DM + DL
• Conversion Cost = DL + FOH
• Manufacturing Cost = Direct Material Cost + Direct Labor Cost +
FOH
• Manufacturing Cost = PC + CC – DL 13
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4. The period to which the cost is charged to income
• Costs may also be classified on the basis of the time or accounting
period they are deducted revenue.
• Some costs are first recorded as assets and then expensed as they are
used or expired.
• Other costs are immediately expensed in the year of incurrence.
• Product costs and periodic costs are the two categories according to
this classification.
Inventorable cost /Product costs: are DMC , DLC and FOHC.
 These costs provide no benefit until the product is sold
 Product costs are added to units of product (i.e., "inventoried") as they
are incurred and are not treated as expenses until the units are sold.
Periodic costs: are non manufacturing cost.
 They are expensed (charged against revenue) immediately and are
therefore non- inventoriable.
 All selling and administrative costs are typically considered to be
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periodic costs.
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5. Behavioral classification
 Taking the response of a cost to changes in production volume ,
we can classify costs into variable, fixed, and mixed.
 Variable costs:
 are costs that change in direct proportion to changes in
volume of production, whereas the unit cost remains
constant.
 Variable costs are easily traceable to units of output and are
controlled by the department head responsible for incurring
them.
 Examples: DMC and DLC
 Fixed costs:
 are costs that remain constant over a relevant range of
output, whereas the fixed cost per unit varies inversely with
output.
 Relevant range is the range over which total fixed costs
remains constant
 Examples :Rent, insurance, depreciation, salaries, advertising
 Behavioral classification
Mixed costs:
• These are costs that contain both fixed and
variable characteristics over various relevant
ranges of operation.
• Example: Utility costs
• The following table summarizes unit costs and
total costs:
As output increases:
In Total Unit Cost
• Variable Cost ........Increases Constant
• Fixed Cost............ Constant Decreases
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 6. The ability to be traced
• A cost may be classified as direct and indirect based on
management ability to trace it to specific jobs,
departments and units
• Direct costs:
– These are costs that could be traced to specific units in
a cost-effective manner.
– Example: Direct material and direct labor costs
• Indirect costs:
• are costs that are common to many cost objects
• are not directly traceable to any specific item (cost object).
• These costs are usually charged to product (cost objects)
through allocation techniques.
• Example: FOH costs are indirect costs. 18
7. Relationship of cost to planning, controlling, and decision making

• Every decision involves choosing from among at least

two alternatives. Only those costs and benefits that
differ between alternatives are relevant in making the
selection
• On these this bases we have cost likes:
a. Relevant and irrelevant costs
b. Controllable and uncontrollable costs
c. Standard and budgeted costs:
d. Opportunity costs.
e. Sunk cost.

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 Relevant and Irrelevant Costs
• A relevant cost is a future cost that differs among
alternatives.
• An irrelevant cost is one that is the same for all decision
alternatives. These costs need not to be considered for
decision .
Controllable and Uncontrollable Costs
• Controllable costs are those which may be directly
influenced by unit managers in a given time period.
• Non-controllable costs are those costs which are
not directly administered at a given level of
management authority.
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Sunk Cost:
 is a cost that has already been incurred and that cannot be
changed by any decision made now or in the future.
 Since sunk costs cannot be changed and therefore cannot be
differential costs, they should be ignored in decision-making.
 A sunk cost is an amount of cash that has been spent and it
cannot be recovered. For example, if you are considering selling a
used car, the amount you paid for it two years ago is sunk. It
should not influence the amount you accept when you sell the
car. The value of a used car is set by the market. There is an
active market for all types of used cars.
 A sunk cost is by definition irrelevant because it cannot differ
across decision alternatives. The two alternatives here are: (1)
sell the car, or (2) keep the car. The amount paid for the car in the
past is the same either way and cannot influence the decision.

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Shutdown costs: - are fixed costs that would be incurred
even if there were no production.

Opportunity Costs
• An amount or benefit given up when choosing a
particular course of action
• Never recorded in accounting records
• Always part of management decision making
 Identifying work flow of a manufacturing firm
Work flow
• A firm’s cost accounting system parallels its flow of
operations. The steps in a typical cycle of operations of a
firm that makes and sells its own products are outlined
below.
• Procurement: Raw materials and supplies needed for
manufacturing and ordered, received, and stored. Direct
and indirect factory labor and services are obtained.
• Production: Raw materials are transferred from the
storeroom to the factory labor, tools, machines, power, and
other costs are applied to complete the product.
• Warehousing: Finished goods are moved from the factory
to the warehouse to be held until they are sold.
• Selling: merchandise is shipped from the warehouse 24
 Manufacturing Cost Flows
Balance Sheet Income
Costs Inventories Statement
Expenses
Material Purchases Raw Materials

Direct Labor Work in

Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold

Selling and Period Costs Selling and

Administrative Administrative
Fall 2010 Mugan 25/82
 Recording Cost Flows
When raw material are purchased:
Raw materials………………………………………………………….xxx
Cash/ Account payable………………………………………………………..xxx
When raw materials are used:
Work-in-process(DM)……………………………………….……...xxx
Manufacturing overhead control(IDM)……………….…….xxx
Raw materials……………………………………………………….……….xxx
When factory wages are Paid
Work-in-process(DL)…………………………………………..xxx
Manufacturing overhead control(IDL)……………..…xxx
Cash/ wage Payable………………………………………………………….xxx
• When other manufacturing overhead costs are incurred:
Manufacturing overheads overhead control……….. xxx
Voucher payable and other accounts…… …xxx
When factory overhead costs are allocated to a product :
Work-in-process………………………………xxx
Manufacturing overhead control…………..xxx
When finished goods are transferred from factory to the store:
Finished goods…………………………………xxx
Work-in-process……………………………xxx
When finished products are sold:
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Cost of goods sold……………………………….....xxx
 Example: 1
• To illustrate the flow of cost, consider the following transactions for a company and
pass the necessary journal entries assuming perpetual inventory system is used.
a. Materials purchased on account $140,000
b. Materials requisitioned:
– Direct…………..$85,000
– Indirect…………$15,000
c. Total payroll of the company for a period $ 180,000. Payroll was paid after
deducting 12% income tax and 7% pension contribution.
• The distribution of the payroll was:
• Direct labor…………..60%Marketing Department…………….18%
• Indirect labor…………15% Administrative Department...……..7%
d. Other factory overhead consists of:
– Depreciation……………$8,500
– Insurance Expired………$1,200
– Others general factory overhead costs $26,340, 70% paid in cash.
e. Factory overhead of 78,040 was allocated to product
f. Work completed and transferred to finished goods $120,000
g. Sales for the period total $100,000, 40% received in cash and 75% of the sales
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price represents cost of goods sold. The cost of manufacturing the sold products is
 Example: 2
• The following data belong to a company for a period.
 Materials used $10,000 (80% for DM)
 Labor used $50,000(70% for DL)
 FOH cost (others) $5,000 (Heat, Light, Power)
• Instruction: Compute:
a. prime cost
b. Total FOH cost
c. Conversion cost
d. Production cost (mfg)
e. Direct cost
f. Indirect cost
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 REPORTING THE RESULTS OF OPERATIOINS

Income Statement
Net sales…………………………………………………………….. XXX
Less : Cost of goods sold…………………………………… ( XX)
Gross profit………………………………………………………… XX
Less: selling and administrative expense…………… (XX)
Net income (Net loss)……………………………… ……….XXX

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 Cost Of Goods Sold Schedule
Beginning Finished Goods Inventory ……………….. XXX
Add : Cost of goods manufactured during the year XX
Goods Available for sale…………………………………… XX
Less: Ending Finished Goods Inventory …………… (XX)
Cost of Goods Sold ……………………………………………….XXX

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 Cost of goods manufactured schedule
Raw material inventory beginning……………………………..$XXX
Add: Raw material purchase during the year …………….XXX
Raw materials available for use………………………….…….. XXX
Less: Raw materials inventory ending………….…….……. (XXX)
Raw materials used (consumed)………………………….……. XXX
Less: Indirect materials used… …….……………………..………. XX
DM used(DMC)…………………………… …………………….…….…... XXX
Add: Direct labor Cost ………………………………… …………………. XXX
: FOH Allocated…………………………….……………………..……. .XXX
Total manufacturing cost……………………………………….………… XXX
Add: WIP beginning……………………………………………………………… XXX
Cost of goods that have been in process during the period……… .……..XXX
Less: WIP ending…………………………………………………………. .……… XXX
Cost of finished goods manufactured during the period……….……….. XXX

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• Example 1
• The following information appeared in the
financial statements of ABC Company on 31st
December 2004.
• Cost of goods manufactured ………………$405,000
• Cost of direct materials used……………. 160,000
• FOH, 80% of direct labor cost…………….. 92,000
• Work in process (ending)……………………… 48,000
• Required:
• Compute: work in process on January 1, (at the
beginning of the year)

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 Example 2
• Assume all the data in Example 1 above and the following
additional information for ABC Company.
• Direct materials (beg)………………………………. $80,000
• Direct materials purchased………… ………….$270,000
• Finished Goods available for sale $500,000
• Finished goods inventory (ending)………….$120,000
• Required: - prepare the cost of goods sold schedule.

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The End

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 EXCERCISE
• The following information was extracted from the
accounting records of Roosevelt Manufacturing Company:
• Direct materials purchased 80,000
• Direct materials used 76,000
• Direct manufacturing labor costs 10,000
• Indirect manufacturing labor costs 12,000
• Sales salaries 14,000
• Other overhead cost 22,000
• Selling and administrative expenses 20,000
• What was the cost of goods manufactured?

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• Beginning of 2017 End of2017
• Direct materials inventory 124,000 73,000
• Work-in-process inventory 173,000 145,000
• Finished-goods inventory 240,000 206,000
• Purchases of direct materials 262,000
• Direct g labor cost 217,000
• Indirect g labor cost 97,000
• Factory insurance 9,000
• Depreciation—Factory equipment 45,000
• Factory utilities 26,000
• Repairs and maintenance- Factory 12,000
• Marketing and distribution costs 125,000
• General and administrative costs 71,000
a. Compute the cost of goods manufactured for 2017.
b. Compute Cost of goods sold

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• A fire completely destroyed a plant and its contents on February 26 th.
Fortunately certain accounting records were kept in another building. They
revealed the following for 31st December 2002 to February 26th2003.
• Sales………………………………………………………… $500,000
• Direct labor cost…………………………………………… 180,000
• Prime cost…………………………………………………….. 294,000
• Gross profit rate………………………………………………….. 20%
• DM purchased………………………………………………… 160,000
• Cost of goods available for sale…………………… 450, 000
• DM (12, 31, 2002)……………………………………………..160,000
• WIP (12, 31, 2002)……………………………………………..34, 000
• F.G (12, 31, 2002)……………………………………………... 30, 000
• FOH 40% of conversion cost………………………………….. ?
• Instruction: Compute the cost of
a. DM inventory lost by fire(Ending DM inventory)
b. WIP inventory lost by fire(ending WIP inventory)
c. F.G inventory lost by fire(ending F.G inventory )
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