CHAPTER 2

COSTCONCEPT AND CLASSIFICATION

 Learning Objectives
◦ Upon completion of this chapter, you should be able to:

◦ Distinguish between cost , expenses, and loses.

◦ Distinguish between direct and indirect cost.
◦ Define the three integral component of a product.
◦ Define prime cost and conversion costs.
◦ Define variable, fixed, and mixed costs and discuss the effects of changes in volume on these costs.
◦ Distinguish between common costs and joint costs.
◦ Distinguish between capital expenditures and revenue expenditures.
◦ Identify the costs for planning, control and analytical processes.
◦ Cost are associated with all types of organization – business, non- business, service, retail, and
manufacturing. Generally, the kinds of costs that are incurred and the way in which these costs are
classified will depend on the type of organization involved.
◦ Our initial focus will be on a manufacturing, but in out discussion we should be aware that, in a
conceptual sense, manufacturing encompasses much more than just firm in the industrial sector of our
economy. It also encompasses many organizations that are typically viewed as being service in nature,
such as movie studious and fast-food outlets. Organization such as these are involved in manufacturing in
the sense that they create a distinct product or customers or patrons. As we proceed with our discussion,
therefore, we should keep in mind that manufacturing is a board term, and that the cost included under
the manufacturing heading have application to a wide range of organization – many of which may be
involved in service-type activities. An understanding of the cost structure of a manufacturing company
therefore provides a board, general understanding of costing that can be very helpful in understanding the
cost structure of other type of organization.
◦ Before cost terminology can be discussed the term cost itself must be defined. Cost is the cash to cash
equivalent value satisficed for goods and services that are expected to bring a current or future benefit to
the organization. We say cash equivalent because non-cash assets can be exchange for the desired goods
or services. For examples, it may be possible to exchange land for some needed equipment.
◦ Cost incurred to produced future benefits in a profit making firm, future benefits usually mean revenue.
As cost are used up in the production of revenues, they are said to expire. Expired costs are used up in
the production of revenues, they are said to expire. Expired costs are called expenses. In each period,
expenses are deducted from revenues in the income statement to determine the period’s profit. A loss is a
cost that expires without producing any revenue benefit. The focus of cost accounting is on costs, not
expenses.
CLASSIFICATION OF COST
I. Cost classified as to relation to a product
A. Manufacturing cost/ product costs
1. Direct materials
2. Direct labor
3. Factory overhead

B. Non- manufacturing cost/ period costs

1. Marketing or selling expense
2. General or administrative expense
II. Cost classified as to variability
A. Variable costs
B. Fixed costs
C. Mixed costs
CLASSIFICATION OF COST
III. Cost classified as to relation to manufacturing departments
A. Direct departmental charges
B. Indirect departmental charges

IV. Cost classified to their nature as common or joint

A. Common costs
B. Joint cost

V. Cost classified as to relation to an accounting period

A. Capital expenditures
B. Revenue expenditure

VI. Cost for planning, control, and analytical processes

A. Standard costs
B. Opportunity costs
C. Differential cost
D. Relevant cost
E. Out-of-pocket cost
F. Sunk cost
G. Controllable cost
MANUFACTURING COST/ PRODUCT COST/ INVENTORIABLE COSTS

Direct materials

◦ Direct materials are the basic ingredients that are transformed into finished products through the use of
labor and factory overhead in the production process. Direct materials are those that can be traced to the
finished product can they form part of the product.
◦ All manufactured products are made from basic direct materials. The basic material may be iron ore for
steel, sheet steel for automobiles, flour for bread, wood tables and chair,. These examples show the link
between a basic raw materials and a final product.
◦ The way a company buys, stores, and uses materials is important. Timely purchasing is important because
if the company runs out materials, the manufacturing process will be forced to shut down. Shutting down
production results in no products, unhappy customers, and loss of sales and profits. Buying too many
direct materials, on the other hand, can lead to high storage costs.
MANUFACTURING COST/ PRODUCT COST/ INVENTORIABLE COSTS

Direct materials

◦ Proper storage of materials will avoid waste and spoilage. Large enough storage space and orderly storage
procedures are essential. Materials must be handled and stored properly to guarantee their satisfactory use
in production. Proper records reduce problems caused by lost or misplaced items.
◦ Direct materials are materials that become part of a finished product and can be conveniently and
economically traced to specific product units. The costs of these materials are direct costs. In some cases,
however, even though a material becomes part of a finished product, the expense of actually tracing the
cost of a specific materials is too great. Some examples of this include nails in furniture, bolts in
automobiles, and rivets in airplanes. These minor materials and other production supplies that cannot be
conveniently or economically traces to specific products are accounted for as indirect materials. Indirect
materials costs are part of factory overhead costs.
MANUFACTURING COST/ PRODUCT COST/ INVENTORIABLE COSTS

Direct labor

◦ Direct labor represent the amount paid as wages to those working directly on the product. Labor services
are, in essence purchased from employees working in the factory. In addition, other type of labor are
purchased from people and organization outside the company. The labor costs usually associated with
manufacturing include machine operators; maintenance worker; managers and supervisors; support
personnel; and people who handle, inspect, and store materials. Because these people are all connected in
some way with the production process, their wages and salaries must be accounted for as production costs
and, finally, as costs of products. However, tracing many of these costs directly to individual products is
difficult.
◦ To help overcome this problem, the wages of machine operators and other worker involved in actually
shaping the product are classified as direct labor costs. Direct labor cost include all labor costs for
specific work performed on products that can be conveniently and economically traced too end productts.
MANUFACTURING COST/ PRODUCT COST/ INVENTORIABLE COSTS

Direct labor

◦ Labor costs for production related activities that cannot be conveniently and economically traced to and
products are called indirect labor cost. These costs include the wages and personnel. Like indirect
materials costs, indirect labor costs are accounted for as factory overhead costs. Payroll related costs, such
as payroll taxes, group insurance, sick pay, vacation and holiday pay, and other fringe benefits can be
considered as part of direct labor costs, but are usually included as factory overhead.
◦ Direct labor plus direct materials = prime costs, while direct labor plus factory overhead = conversion
cost.
◦ Total manufacturing cost = direct materials + direct labor + factory overhead
MANUFACTURING COST/ PRODUCT COST/ INVENTORIABLE COSTS

Direct labor

◦ Direct labor plus direct materials = prime costs, while direct labor plus factory overhead = conversion
cost.
◦ Total manufacturing cost = direct materials + direct labor + factory overhead

Prime Costs

Direct materials Direct labor Factory overhead

Conversion Costs
NON-MANUFACTURING COSTS/PERIOD COSTS

Marketing or selling expenses

◦ Marketing or selling expenses include all costs necessary to secure customer orders and get the finished
product or service into the hands of the customer. Since marketing expenses are often referred to as order-
getting and order-filling cots. Examples of marketing expenses include advertising, shipping, sales travel;
sales commissions, sales salaries, and expenses associated with finished goods warehouses. All
organizations have marketing costs, regardless of whether the organization have marketing costs,
regardless of whether the organizations are manufacturing, merchandising, or service in nature.
NON-MANUFACTURING COSTS/PERIOD COSTS

Administrative or general expenses

◦ Administrative expense include all executive, organizational, and clerical expenses that cannot logically
be include under either production and marketing. Example of such expenses include executive
compensation, general accounting, secretarial, public relation, and similar expenses having to do with the
overall, general administration of the organization as a whole. As with marketing expenses, all
organization have administrative expenses.
COST CLASSIFIED AS TO VARIABILITY

Fixed, Variable, and mixed

◦ One of the most important cost classifications involves the way a cost changes in relation to changes in
the activity of the organization. Activity refers to a measure of the organization’s output of products or
services. In specifying cost behavior, the managerial accountant often limits the description to specific
range of activity. This is called the relevant range.
 COST CLASSIFIED AS TO VARIABILITY

Fixed Cost

◦ Items of cost which remain constant in total, irrespective of the volume of production. Fixed cost are not
related to activity within the relevant range. If activity increase or decreases by 20 percent, total fixed cost
remains the same. Cost per unit decreases as volume increases, and increases as volume decreases. Fixed
costs are assignable to departments based on difference allocation methods. Examples are salaries of
production executives, depreciation of equipment computed on straight-line basis, periodic rent payments,
and insurance.
 COST CLASSIFIED AS TO VARIABILITY
Fixed Cost
◦ Fixed costs may classified into two categories, depending on the ability of
management to influence the levels of these costs in the short-term.
1. Committed fixed costs – costs that represent relatively long term commitments on the part
of management as a result of a past decision. Example – depreciation on equipment.

2. Managed fixed costs (also known as discretionary, programmed, or planned, fixed costs) –
costs that are incurred on a short term basis and can be more easily modified in response to
changes in management objectives. Examples – advertising, research and development
and costs of training of employees
Shown on the next page is graph of fixed costs. It is clearly shown that total fixed cost remains unchanged
as activity changes. When activity triples, from 10 to 30 units, total fixed cot remains constant at php1,500.
if activity level is only 1 unit, then the fixed cost per unit is php1,500. if the activity level is 10 units, then
the fixed cost per unit declines to php150 per unit. So we can conclude that fixed cost per unit will decrease
as we increase the volume or units of production and fixed cost per unit will increase as we decrease the
volume of production.
Total fixed cost

1,500

10 20 30 Activity

Graph of total fixed cost

Activity Fixed cost per unit Total fixed Cost

1 Php 1,500 1,500
2 750 1,500
5 300 1,500
10 150 1,500
20 75 1,500
30 50 1,500
 COST CLASSIFIED AS TO VARIABILITY

Variable Cost

These are the items of cost which vary directly, in total, in relation to volume of production. If activity
increases by 20% also. Cost per unit remains constant as volume changes within a relevant range. Example
are: direct materials, direct labor, royalties, and commission of salesman.
 Total variable cost increases proportionately with activity. When activity doubles from 10 to 20 units, total
variable cost doubles, from Php1,000 to php2,000. however variable cost per unit remains the same as
activity changes. The variable cost associated with each unit of activity is php100, whether it is the first
unit, the fourth, or the tenth.
To summarize, as activity changes, total variable cost increases or decreases proportionately with the
activity change, but unit variable cost remains the same.
Total Variable Cost

3,000

2,000

1,000

Activity
Graph of total variable cost 10 20 30
TABULATION OF VARIABLE COST

Activity Variable cost per unit Total Variable Cost

1 Php 100 Php 100

10 100 1,000
20 100 2,000
30 100 3,000
 COST CLASSIFIED AS TO VARIABILITY
Mixed Cost
Items of cost with fixed and variable components. Mixed cost vary with level of production, though not in
direct relation to it, probably because part of the cost is fixed while the rest is variable. Two types of mixed
costs exist – semi-variable costs and step costs.

Semi-variable cost
The fixed portion of semi-variable cost usually represent a minimum fee for making a particular item or
service available. The variable portion is the cost charged for actually using the service. The cost of
electricity where there is a basic minimum charge plus a specified cost peer kilowatt hour above the
minimum is an example of such semi-variable cost. The cost charged for using a cellphone under plan is
also an example of a semi-variable cost. The cost of the plan is fixed and it is for a specified time used,
however if the user exceeds the time allowed, then charges will be made on a per minute basis.
 Semi-variable cost
Semi-variable cost
35,000
30,000 Variable
(P 15, 000)
25,000
20,000
15,000
10,000 Fixed
(P 20, 000)
5,000
0 1 1

5000 KILOMETERS
Assume that a company rents a delivery truck at a flat rate of p 20,000 per month plus p 1.50/km driven.
The fixed portion is the p20, 000 monthly rental fee; the variable portion is the p1.50/km driven. If 10,000
km are driven during the month, the total monthly cost of the delivery truck is p35,000 computed as
follows;
Flat fee (fixed portion) p20,000
Variable portion -10,000km x p1.50 15,000
Total cost P 35, 000
 Step cost – the fixed part of step costs changes abruptly at various activity levels because these costs are
acquired in indivisible portions. A step cost is similar to a fixed cost within a very small relevant range.

180,000

150,000

120,000

90,000

60,000

30,000
10 20 30 40 50 (no. of workers)
0
The supervisor’s salary is an example of step cost. Assume that one supervisor with a salary of P30, 000 is
needed for every 10 workers, then if 15 workers are used, 2 supervisor (with salaries of P60,000) will be
needed. If 18 workers are used, still 2 supervisors would be needed. If the number of workers increases to
22 , three supervisors would be needed.
Ideally, for both planning purposes and for making certain types of decisions, all costs would be classified
as either fixed or variable, with semi-variable cost being separated into their fixed and variable components.
One of the most important steps in estimating the variable and fixed components of a mixed cost is to
examine the cause and effect relationship between activities that affect costs,. There are different methods of
separating mixed costs into fixed and variable components;
(1) scattergraph
(2) high-low point
(3) method of lease square.
Summary of electricity cost and direct labor hours
Month Direct labor hrs. Cost of electricity
January 28 P 625
February 24 565
March 30 630
April 33 640
May 38 685
June 34 640
July 35 655
August 40 700
September 42 715
October 47 726
November 43 700
December 32 630
Summary of electricity cost and direct labor hours

Direct labor hrs. Cost

Highest month (October) 47 P 726
Lowest month (February) 24 565
Difference 23 161

Variable rate per direct labor hour = P 161

23 hours
= P7/direct labor hour
 Fixed cost can be computed from either the high or low data

High Low
Total cost of electricity P 726 565
Less: variable portion
(P 7 x 47) 329
(P 7 x 24) 168

P 397 P 397

The formula for projecting the total monthly cost of electricity based on these data would be P397 plus 7
multiplied by the direct-labor hours expected to be worked during the period (Y = FC + VC or Y = FC
+VC) where
Y = Total Cost VC = Total variable cost
V= Variable Cost per unit FC = Fixed Cost
X = Activity level
METHOD OF LEAST SQUARE

The three formula to be used in least-square method are:

Equation 1 Y = a + bx
Equation 2 ΣY = na + bΣx
Equation 3 ΣXY = Σxa +bΣx²
Using the same data as in the high-low method the following have beed computed
DLHrs. Electricity Cost
X Y XY X²
28 625 17,500 784
24 565 13,560 576
30 630 18,900 900
33 640 21,120 1,089
38 685 26,030 1,444
34 640 21,760 1,156
35 655 22,925 1,225
40 700 28,000 1,600
42 715 30,030 1,764
47 726 34,122 2,209
43 700 30,100 1,849
32 630 20,160 1,024
Σ= 426 7911 284,207 15,620
By substitution:
Equation 2 ΣY = na + bΣx
(7,911 = 12a + b426) 35.5 (426/12)
Equation 3 ΣXY = Σxa +bΣx²
284,207 = 426a + b15,620
Equation 2 280, 840.50 = 426a + b15,123
3,366.5 = 0 b 497
b = 3,366.5 / 497
b = 6. 77
Substituting the value for Equation 2, we can compute for a as follows
7,911 = 12a + (6.77)(426)
7,911 = 12a + 2,884
12a = 7911 – 2,884
a = 5,027/12
= 418.92
Formula using high-low method
Y = a + bx
= 397 + 7x

Formula using least square method

Y = a + bx
= 419 + 6.77x

In most cases the amounts derived using high/low point and method of least square are not the same.
 COMMON COST VS. JOINT COST
Common cost
Cost of facilities or services employed in two or more accounting periods operations, commodities, or
services. Just like indirect costs, these cost are subject to allocation. Example – if two departments are
occupying the same building, the depreciation of the building id a common cost subject to allocation based
on floor area occupied.

Joint cost
Costs of materials, labor, and overhead incurred in the manufacture of two or more products at the same
time. A major difficulty inherent to joint costs in the they are indivisible and they are not specifically
identifiable with any of the products being simultaneously produced. These costs are also subject to
allocation. example – direct materials, direct labor, and factory overhead cost incurred to manufacture two
or more products up to the point of split-off (or where they will go separate ways)
 CAPITAL EXPENDITURE VS. REVENUE
AXPENDITURE
Capital expenditure
Expenditure intended to benefit more then one accounting periods and is recorded as an asset. The
allocation of the cost to the different periods is – depreciation for fixed tangible assets, amortization for
intangible assets and depletion for wasting assets.

Revenue Expenditure
Expenditure that will benefit current period only and is recorded as an expense.
Cost for Planning, control and analytical processes
Standard costs
Predetermined costs for direct materials, direct labor, factory overhead. They are established by using
information accumulated from past experience and data secured from research studies. In essence, a
standard cost is a budget for the production of one unit of product or service. It is the cost chosen by the
managerial accountant to serve as the benchmark in the budgetary control system

Opportunity costs
The benefit given up when one alternative is chosen over another. Opportunity costs are not usually
recorded in the accounting system. However, opportunity costs should be considered when evaluating
alternatives for decision-making. If an asset can be used to perform only one function and cannot be sold or
used in other ways the opportunity cost of that asset is zero.
Cost for Planning, control and analytical processes

Example 1
Michelle has a part-time job that pay her P 1, 000 per week. She would like to spend a week in Boracay
during summer vacation from school, but she has no vacation time available. If she takes the trip anyway,
the P1, 0000 in lost wages will be an opportunity cost of doing so.

Example 2
Marco is employed with a company that pays him a salary of P20, 000 a month. He is thinking about
leaving the company and returning to school. Since returning to school would require that he give up his
P240,000 salaries, the forgone salary would be an opportunity cost of seeking further education.
Cost for Planning, control and analytical processes

Differential Cost

◦ Cost that is present under one alternative but is absent in whole or in part under another alternative. An
increase in cost from one alternative to another is known as incremental cost , while a decrease in cost is
known as decremental cost, differential cost I a broader term, encompassing both cost increase and cost
decrease between alternatives.
◦ The accountant’s differential cost concept is basically the same as the economist’s marginal the terms
marginal cost and marginal revenue. The revenue that cann be obtained from selling one more unit of
product is called marginal revenue, and the cost involved in producing one more unit of product is called
marginal cost.
Differential Cost
Differential cost can be either fixed or variable. To illustrate, assume that Avon Corp. is thinking about
changing its marketing method from distribution through retailers to distribution by direct sale. Present
costs and revenues are compared to projected costs and revenues in the table.
Retailer Direct sale Differential
Distribution Distribution Cost and
(present) (proposed) Revenues
Revenue P 900,000 P 1, 200,000 P 300,000
Cost of Goods sold (V) 450,000 600,000 150,000
Advertising (F) 80,000 45,000 (35,000)
Commission (V) - 40,000 40,000
Warehouse depreciation (F) 50,000 80,000 30,000
Other Expenses (F) 60,000 60,000 -
Total 640,000 825,000 185,000
Net Income P 260,000 P375,000 P 115,000
Cost for Planning, control and analytical processes

Relevant Cost

A future cost that changes across the alternatives. In the example above, the relevant cost are cost of goods
sold, advertising, commissions, and warehouse depreciation.

Out-of-pocket cost

Cost that requires the payment of money (or other assets) as a result of their incurrence.
Cost for Planning, control and analytical processes

Sunk Cost

Future decision, they are not different costs, and therefore they should be used in analyzing future courses of
action.
To illustrate the notion of sunk cost, assume that a firm has just paid P 250,000 for a special purpose
machine. Since the cost outlay has been made, the P 250,000 investment in the machine is a sunk cost. Even
though the purchase may have been unwise, no amount of regret can relieve the company of its decision,
nor can any future decision cause the cost to be avoided.
Controllable and Non-controllable Costs

A cost is considered to be a controllable cost at a particular level of management if that level has power to
authorize the cost. For example, entertainment expense would be controllable by a sales manager if he or
she had power to authorize the amount and type of entertainment for customers. On the other hand,
depreciation of warehouse facilities would not be controllable by the sales manager, since he or she would
have no power to authorized warehouse construction.
In some situations, there is a time dimension to controllability. Costs that are controllable over the long run
may not be controllable over the short run. A good example is advertising. Once an advertising program has
been set and a contract signed, management has no power to change the amount of spending. But the
contract expires, advertising cost can be renegotiated, and thus management can exercise control over the
long run.
COST FLOW –MANUFACTURING FIRMS
Cost incurrence Expense category

Direct materials ------------}

Work in Finished
Direct Labor -----------} Cost of goods sold
Process Goods

Factory overhead ----------}

Selling and Administrative Operating Expenses

Work in process consists of goods that are stated but not completed. Finished goods are goods that are
complete and ready for sale.
COST FLOW –MERCHANDISING FIRMS
Cost incurrence Expense category

Finished goods Cost of goods sold

Selling and Administrative Operating Expenses

COST FLOW – SERVICE FIRMS
Cost incurrence Expense category

Direct materials -------------

Direct Labor ------------------ Cost of Service

Factory overhead ----------

Selling and Administrative Operating Expenses

The essential purpose of any organization is to transform inputs into outputs. These organizations have
many similarities, all require labor and capital as inputs, and al transform them into a product or service for
the market. These organizations also differ from one another in many respects. The differences between
these organization are reflected in their accounting systems.
A merchandising organization starts with a finished product and market it. Because inventory is acquired in
finished form, its cost is easily ascertained.
The accounting system for a manufacturing organization is more complex because direct materials are first
acquired and then converted to finished products. A manufacturer’s accounting system focuses on work in
process, which is the account manufacturer’s account reflects the costs involved in transforming input
materials into finished goods.
Service organizations are different from manufacturing and merchandising because they have no inventory
of goods available for sale. Costs are charged to responsibility centers or performance evaluation. In a
public accounting firm, for example, cost are charge to the audit department, the tax department, and so
forth. Costs are also charged to jobs. The assignment of cost facilities performance evaluation. The manager
each department is held responsible for the costs of the department, the manager of each job is held
responsible for the cost of that job. Of the three kinds of operations, manufacturers require the most
complex and comprehensive cost accounting system. All three uses cost information for decision making
and performance evaluation. But in addition, manufacturers need product costing for inventory valuation
and to measure cost of goods sold reported on external financial statement. Many manufacturers also have
service and merchandising activities, cost of which mush be recorded.
SUMMARY OF IMPORTANT FORMULAS

1. Total variable costs = Variable cost peer unit x total output

2. Total cost = Total variable cost total fixed cost

3. Variable rate = highest point cost – lowest point cost

Highest output – lowest output
4. Fixed cost = Total cost at highest – (variable rate x output at highest point) or

5. Fixed cost = Total cost at lowest – (variable rate x output at lowest point)