MODULE
2
Week 2
COST CONCEPTS AND
CLASSIFICATION
INTRODUCTION
This module is about the definition, classification and formulas of cost.
INTENDED LEARNING OUTCOMES
Students are expected of the following upon completion of Module 2
a.
b.
c.
d.
e.
Distinguish between cost, expenses, and losses
Distinguish between direct and indirect costs
Define the three integral components of a product
Define prime costs and conversion costs
Define variable, fixed, and mixed costs and discuss the effects of changes in
volume of these costs
f. Distinguish between common costs and joint costs
g. Distinguish between capital expenditures and revenue expenditures
h. Identify the costs for planning, control and analytical processes
CONTENT
COSTS CLASSIFIED AS TO RELATION TO A PRODUCT
Manufacturing Costs/Product Costs/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.
Direct Labor
Direct labor represents the amount paid as wages to those working directly on the product. The
labor costs usually associated with manufacturing include machine operators; maintenance
workers; managers and supervisors; support personnel; and people who handle, inspect and store
materials.
Direct labor costs include all labor costs for specific work performed on products that can be
conveniently and economically traced to end products.
Indirect labor costs are labor costs for production related activities that cannot be conveniently
and economically traced to end products. These costs include the wages and salaries of such
workers as machine helpers, supervisors, and other support personnel. Like indirect material
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.
prime costs = direct labor cost plus direct materials
conversion costs = direct labor plus factory overhead
Total manufacturing costs = direct material + direct labor + factory overhead
Factory Overhead
The third manufacturing cost element is a catchall for manufacturing costs that cannot be
classified as direct materials or direct labor costs. Factory overhead costs are a varied collection
of production-related costs that cannot be practically or conveniently traced directly to end
products. This collection of costs is also called manufacturing overhead, factory burden, and
indirect manufacturing costs.
Examples of the major classifications of factory overhead costs are:
Indirect materials and supplies: nails, rivets, lubricants, and small tools.
Indirect labor costs: lift truck driver’s wages, maintenance and inspection labor,
engineering labor, machine helpers and supervisors.
Other indirect factory costs: building maintenance, machinery and tool maintenance,
property taxes, property insurance, pension costs, depreciation on plant and equipment,
rent expense and utility expense.
Non-manufacturing Costs/Period Cost
Marketing of 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 relate to
contacting customers and providing for their needs, these expenses are often referred to as ordergetting and order-filling costs. Examples of marketing expenses include advertising, shipping, sales
travel; sales commissions, sales salaries, and expenses associated with finished goods warehouses.
Administrative or general expenses
Administrative expenses include all executive, organizational, and clerical expenses that cannot
logically be included under either the production or marketing. Examples of such expenses include
executive compensation, general accounting, secretarial, public relations and similar expenses
having to do with the overall, general administration of the organization as a whole. As with
marketing expenses, all organizations have administrative expenses.
COSTS 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 a specific range of activity. This is called the relevant range.
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 increases 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 different departments based on
difference allocation methods. Examples are salaries of production executives, depreciation of
equipment computed on a straight-line basis, periodic rent payments and insurance.
Fixed costs may be 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 past decision. Example – depreciation on equipment
2) Managed 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 employees.
Variable costs
These are the items of costs which vary directly, in total, in relation to volume of production. If
activity increases by 20 percent, total variable costs increases by 20 percent also. Cost per unit
remains constant as volume changes within a relevant range. Examples are direct materials, direct
labor, royalties and commission of salesmen.
Mixed Cost
Items of cost with fixed and variable components. Mixed costs vary with the 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 – semivariable costs and step costs.
Semi-variable cost. The fixed portion of a semi-variable cost usually represents 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 per kilowatt hour above the minimum is an example
of such a semi-variable cost. The cost charged for using a cellphone under a plan is also an
example of a semi-variable cost.
Step costs - the fixed part of step costs changes abruptly at various activity levels because
these costs are acquired in indivisible portions. The supervisor’s salary is an example of
step cost
There are different methods of separating mixed costs into fixed and variable components: (1)
scattergraph, (2) high-low point, (3) method of least square
(1) HIGH-LOW POINT METHOD
Summary of electricity costs and direct labor hours
Month
January
February
March
April
May
June
July
August
September
October
November
December
Highest month (Oct.)
Lowest month (Feb.)
Difference
Direct labor hrs.
Cost of electricity
28
24
30
33
38
34
35
40
42
47
43
32
P625
565
630
640
685
640
655
700
715
726
700
630
Direct labor hrs.
47
24
23
Cost
P726
565
P161
Variable rate per direct labor hour = P161
23 hours
= P7/direct labor hour
Fixed cost can be computed from either the high or low data.
High
Low
Total cost of electricity
P726
P565
Less: variable proportion
(P7 x 47)
(P7 x 24)
Monthly fixed cost
329
168
P397
P397
(2) METHOD OF LEAST SQUARE
The three formulas to be used in least-square method are:
Equation 1
Y = a + bx
Equation 2
ƩY = na + bƩx
Equation 3
ƩXY = Ʃxa + bƩx2
the same data as in the high-low method the following have been 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
Ʃ = 426
7,911
284,207
15,620
By substitution:
Equation 2
Ʃy
(7,911)
=
=
na + bƩx
12a + b(426) 35.5 (426/12)
Ʃxy
284,207
=
=
Ʃxa + bƩx2
426a + b15,620
Equation 2x35.5 280,840.5
3,366.5
b
b
=
=
=
=
426a + b15,123
0 b
3,366.5/497
6.77
Equation 3
497
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
=
7,911 – 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
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 costs are subject to allocation. Example –
if two departments are occupying the same building, the depreciation of the building is 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 is that 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 expenditure
Capital expenditure
Expenditure intended to benefit more than one accounting periods and is recorded as an asset.
The allocation of the cost to the different period 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.
Direct vs. Indirect departmental charges
Direct departmental charges
Costs that are immediately charged to the particular manufacturing department(s) that incurred
the costs since the costs can be conveniently identified or associated with the department(s) that
benefited from said costs.
Indirect departmental charges
Costs that are originally charged to some other manufacturing department(s) or account(s) but
are later allocated or transferred to another department (s) that indirectly benefited from said
costs.
Costs for Planning, control and analytical processes
Standard costs
Predetermined costs for direct materials, direct labor, and 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 in other ways, the opportunity cost of that asset is zero.
Example 1
Michelle has a part-time job that pays her P1,000 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 P1,000 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 foregone salary would be an
opportunity cost of seeking further education.
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 decremental cost.
Marginal revenue is the revenue that can be obtained from selling one or more unit of product
while marginal cost is the cost involved in producing one or more unit of product.
Revenues (V)
Cost of goods sold (V)
Advertising (F)
Commission (V)
Warehouse depreciation (F)
Other expenses (F)
Total
Net Income
Retailer
Distribution
(present)
P 900,000
450,000
80,000
50,000
60,000
640,000
P 260,000
Direct Sale
Distribution
(proposed)
P 1,200,000
600,000
45,000
40,000
80,000
60,000
825,000
P375,000
Differential
Cost and
Revenues
P 300,000
150,000
( 35,000)
40,000
30,000
0
185,000
P 115,000
The differential revenue is P300,000, and the differential costs total P185,000, leaving a positive
differential net income of P115,000 under the proposed marketing plan. As noted earlier, those
differential costs representing cost increases could have been referred to more specifically as
incremental costs, and those representing cost decreases could have been referred to more
specifically as decremental costs.
Relevant cost
A future costs that changes across the alternatives. In the example above, the relevant costs 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.
Sunk cost
To illustrate the notion of a sunk cost, assume that a firm has just paid P250,000 for a special
purpose machine. Since the cost outlay has been made, the P250,000 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 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 pther hand, depreciation of warehouse facilities would not be controllable by the sales
manager, since he or she would have no power to authorize warehouse construction.
COST FLOW – MANUFACTURING FIRMS
Cost Incurrence
Expense Category
Direct Materials-----------}
}
Direct labor-----------------}
}
Factory overhead---------}
Work in
process
Selling and Administrative
Finished
goods
Cost of goods sold
Operating expenses
Work in process consists of goods that are started but not completed. Finished goods are goods
that are complete and ready for sale.
COST FLOW – MERCHANDISING FIRM
Cost Incurrence
Expense Category
Finished goods
Cost of goods sold
Selling and Administrative
Operating expenses
COST FLOW – SERVICE FIRM
Cost Incurrence
Expense Category
Direct Materials-----------}
}
Direct labor-----------------}
}
Factory overhead---------}
Cost of goods sold
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 all transform them into a product
or service for the market. These organizations also differ from one another in many respects. The
differences between these organizations are reflected in their accounting systems.
SUMMARY OF IMPORTANT FORMULAS
1. Total variable costs = Variable cost per 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)
MODULE ACTIVITY/ASSESSMENT
Problem 1
Presented below is a list of costs, and expenses usually incurred by Ram Corporation, a
manufacturer of furniture, in its factory.
1. Metal used in manufacturing tables
2. Insurance on factory machines
3. Leather used in manufacturing furniture
4. Wages paid to machine operators
5. Depreciation of factory machinery
6. Salaries of factory supervisors
7. Wood used in manufacturing furniture
8. Sandpaper, bolts and nails
9. Property taxes on factory buildings
10. Rent of factory building
Instructions
Classify the above items into the following categories (a) direct materials, (b) direct labor and (c)
manufacturing overhead.
Problem 2
Classify the following as to fixed, variable or mixed
1. Factory rent
2. Wages for workers paid based on units produced
3. Equipment maintenance
4. Cost accountant’s salary
5. Depreciation based on output
6. Salary of factory supervisor
7. Telephone (monthly)
8. Paper in the manufacture of books
9. Wages of machine operators
10. Commission of salesmen
Problem 3
Classify the following as either manufacturing (M), selling (S), or administrative (A)
1. Metal for the manufacturer of golf clubs
2. Wages of drivers of delivery trucks
3. Rent on factory building
4. Freight-in of materials purchased
5. President’s salary
Problem 4
Classify each of the following costs of Bug Company in two ways: (a) as variable (V) fixed costs (F);
(b) as inventoriable costs (I) or period costs (P):
Example: Direct labor
1.
2.
3.
4.
5.
6.
7.
8.
9.
Wood used in bookcases
Machine depreciation based on machine Hrs.
Fire insurance on factory equipment
Wiring used in radios
Indirect materials
Sales commissions
Bottles used to package liquid
Gasoline for a delivery truck
Straight-line depreciation of trucks used
for delivery of sales to customers
10. Machine operator’s hourly wages
(a) V or F
V
(b) I or P
I
________
________
________
________
________
________
________
________
________
________
________
________
________
________
________
________
________
________
________
________
Problem 5
Kyrie Company produces different sizes of basketballs. The following costs were incurred during
the year.
Materials
Labor
Factory overhead
General and administrative expenses
Office salaries
P65,000
70,000
95,000
(P15,000 is indirect)
(P18,000 is indirect)
(including indirect materials and indirect
Labor)
2,600
18,600
There were no work in process at the end of the year, 5,000 units were produced, and 90% of the
units produced were sold.
Required:
1. Compute the prime costs
2.
3.
4.
5.
Compute the conversion costs
Compute the total product costs
Compute the total period costs
If the selling price is P50.00, how much is the net income
Problem 6
The financial statements of Mother Goose Company included these items:
Marketing costs
Direct labor costs
Administrative costs
Direct materials used
Fixed factory overhead costs
Variable factory overhead costs
P160,000
245,000
145,000
285,000
175,000
155,000
Compute for the following
1. Prime cost
2. Conversion cost
3. Total inventoriable/product cost
4. Total period cost
Problem 7
Sales price
Fixed costs:
Marketing and administrative
Manufacturing overhead
Variable costs:
Marketing and administrative
Manufacturing overhead
Direct labor
Direct materials
Units produced and sold
Required:
1.
2.
3.
4.
P 200 per unit
24,000 per period
30,000 per period
6 per unit
9 per unit
30 per unit
60 per unit
1,200 per period
Compute for the following
Variable manufacturing cost per unit
Variable cost per unit
Full manufacturing cost per unit
Full cost to make and sell per unit
Problem 8
Given the following facts, complete the requirements below:
Westinghouse Company manufactures major appliances. Because of growing interest in its
product, it has just had its most successful year. In preparing the budget for next year, its
controller compiled these data.
MONTH
JULY
AUGUST
SEPTEMBER
OCTOBER
NOVEMBER
DECEMBER
6-MONTH TOTAL
VOLUME IN MACHINE HOURS
6,000
5,000
4,500
4,000
3,500
3,000
26,000
ELECTRICITY COST
P60,000
53,000
49,500
46,000
42,500
39,000
P290,000
Using the high-low method compute
1. The variable cost per machine hour
2. The monthly fixed electricity cost
3. The total electricity costs if 4,800 machine hours are projected to be used next month
Reference
De Leon, Norma D. Cost Accounting and Control, GIC Enterprises & Co., Inc., 2019 edition