COST TERMS, CONCEPTS and CLASIFICATIONS

COST CONCEPT
Cost - refers to the monetary amount of resources given up to attain set
objectives such as acquiring goods and services.

COST CLASSIFICATION
MANUFACTURING COSTS
• those costs that are directly involved in manufacturing of products
and services.
• Manufacturing cost is divided into three broad categories by most
companies.
1. Direct materials cost
2. Direct labor cost
3. Manufacturing overhead cost.

DIRECT MATERIALS
• are those materials that become an integral part of the finished
product and that can be physically and conveniently traced to it.
• Examples include tiny electric motor that Panasonic uses in its CD
players to make the CD spin, the wood used in making the chairs in
Westwood Industries, the dough used in making the bread at Sweet Sarap
Bakeshop and so on.

DIRECT LABOR
• reserved for those labor costs that can be essentially traced to
individual units of products. Direct labor is sometime called touch
labor, since direct labor workers typically touch the product while
it is being made. The labor cost of assembly line workers, for
example, is a direct labor cost, as would the labor cost of carpenter,
bricklayer and machine operator.

Note: Direct Materials cost combined with direct labor cost is called prime
cost. In equation form: Prime Cost = Direct Materials Cost + Direct Labor
Cost

MANUFACTURING OVERHEAD
• includes all costs of manufacturing except direct material and direct
labor.
• Examples of manufacturing overhead include items such as indirect
material, indirect labor, maintenance and repairs on production
equipment and heat and light, property taxes, depreciation, and
insurance on manufacturing facilities.

Indirect materials - are minor items such as solder and glue in

manufacturing industries. Indirect labor - includes the labor cost of
janitors, supervisors, materials handlers and night security guards.

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Note: Manufacturing overhead cost combined with direct labor is called
conversion cost. In equation form: Conversion Cost = Direct Labor Cost +
Manufacturing Overhead Cost

NON-MANUFACTURING COSTS
• Are those costs that are not incurred to manufacture a product.
• Examples of such costs are salary of sales person and advertising
expenses.
• Classified into two categories.
1. Marketing and Selling Costs
2. Administrative Costs

MARKETING OR SELLING
• Include all costs necessary to secure customer orders and get the
finished product into the hands of the customers.
• These costs are often called order getting or order filling costs.
• Examples of marketing or selling costs include advertising costs,
shipping costs, sales commission and sales salary.

ADMINISTRATIVE
• include all executive, organizational, and clerical costs associated
with general management of an organization rather than with
manufacturing, marketing, or selling.
• Examples of administrative costs include executive compensation,
general accounting, secretarial, public relations, and similar costs
involved in the overall, general administration of the organization
as a whole.

PRODUCT VERSUS PERIOD COSTS

• Costs can also be classified as either product cost or period cost.

PRODUCT COSTS
• Include all the costs that are involved in acquiring or making
product.
• In the case of manufactured goods, these costs consist of direct
materials, direct labor, and manufacturing overhead.
• Since product costs are initially assigned to inventories, they are
also known as Inventoriable costs.

PERIOD COSTS
• Are all the costs that are not included in product costs.
• These costs are expensed on the income statement in the period in
which they are incurred, using the usual rules of accrual accounting
that we learn in financial accounting.

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COST BEHAVIOR
• refers to how a cost will react or respond to changes in the level of
business activity.
• As the level of activity rises and falls, a particular cost may rise
and fall as well--or it may remain constant.

VARIABLE COSTS
• cost that varies, in total, in direct proportion to changes in the
level of activity.
• Direct material is a good example of variable cost.
• Some of the most frequently encountered variable costs are listed
below.

TRUE VARIABLE COST

• Cost that varies in direct proportion to the level of activity.
• Direct material is an example of true variable cost because the amount
used during a period will vary in direct proportion to the level of
production activity.

STEP-VARIABLE COST
• A resource that is obtained only in large chunks (such as maintenance
workers) and whose costs increase or decrease only in response to
fairly wide changes in activity is known as a step-variable cost.

FIXED COST
• A cost that remains constant, in total, regardless of changes in the
level of activity.
• Average fixed cost per unit increases and decreases inversely with
changes in activity.
• Examples of fixed cost include straight line depreciation, insurance
property taxes, rent, supervisory salary etc.
• For planning purposes, fixed costs can be viewed as being either
committed or discretionary.

COMMITTED FIXED COST

• relate to the investment in facilities, equipment, and the basic
organizational structure of a firm.
• Examples of such costs include depreciation of buildings and
equipment, taxes on real estate, insurance and salaries of top
management and operating personnel.

The two key characteristics of committed fixed cost

are 1. They are long term in nature.
2. They cannot be significantly reduced even for short period of time
without seriously impairing the profitability or long run goals of the
organization.

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DISCRETIONARY FIXED COST
• (often referred to as managed fixed costs) usually arise from annual
decisions by management to spend in certain fixed cost areas.
• Examples of discretionary fixed costs include advertising, research,
public relations, management development programs, and internships
for students.

VARIABLE AND FIXED COST BEHAVIOR (SUMMARY)

COSTS TOTAL PER UNIT
FIXED Constant Decreases as
production increases
(Inverse relationship)
VARIABLE Increases as production Constant
increases
(direct relationship)
MIXED/ Increases less Decreases less
SEMIVARIABLE proportionately (vs. proportionately (vs.
total variable costs) unit fixed costs) as
as production increases production increases

MIXED OR SEMI-VARIABLE COST

• contains both variable and fixed cost elements.
• also known as semi variable cost.
• Examples of mixed costs include electricity and telephone bills.

The relationship between mixed cost and level of activity can be expressed
by the following equation or formula:
Y = a + bX

COST BEHAVIOR ASSUMPTIONS and LIMITATIONS

1. Relevant Range – refers to the range of activity within which the
cost behavior patterns are valid. Any level of activity outside
this range may show a different cost behavior pattern.
2. Time – the cost behavior patterns identified are true only over a
specified period of time. Beyond this, the cost may show a
different cost behavior pattern.
3. Linearity – the cost is assumed to manifest a linear relationship
over a relevant range despite tendency to show otherwise over the
long run.

SEGREGATION OF MIXED COSTS INTO FIXED AND VARIABLE COSTS HIGH

AND LOW POINT METHOD
• begin by identifying the period with the lowest level activity and
the period with the highest level of activity.
• The period with lowest level of activity is selected as first point
and the period with the highest activity is selected as the second
point.

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Consequently the formula becomes:
Variable Costs = (Yh − Yl) ÷ (Xh − Xl)
• Yh = Cost at the high level of activity
• Yl = Cost at the low level of activity
• Xh = High activity level
• Xl = Low activity level

LIMITATIONS OF HIGH AND LOW POINT METHOD

• It utilizes only two points and generally two points are not enough
to produce accurate results in cost analysis work.
• Periods in which the activity level is unusually low or unusually
high will tend to produce inaccurate results.

METHOD OF LEAST SQUARES

• The goal of least squares is to define a line so that it fits
through a set of points on a graph, where the cumulative sum of
the squared distances between the points and the line is minimized
(hence, the name "least squares").
• The formula for Least-Squares can be illustrated as follows:
∑y = na + b∑x
∑xy = a∑x + b∑x²

Where: ∑y – represents summation of Total costs. ∑x – represents

summation of Total activities or volume. ∑xy – represents summation
of total activities multiplied by total costs. x² - represents
summation of total activities squared.

SCATTERGRAPH METHOD
All observed costs at various activity levels are plotted on a graph.
Based on sound judgment, a regression line is then fitted to the plotted
points to represent the line function.

OTHER COST ESTIMATION METHODS

1. Industrial Engineering Method – based on the relationship between
inputs and outputs in physical forms; engineering estimates
indicate what and how much costs should be.
2. Accounts Analysis Method – each account is classified as either
fixed or variable based on experience and judgment of accounting
and other qualified personnel in the organization.
3. Conference Method – costs are classified based on opinions from
various company departments such as purchasing, process
engineering, manufacturing, employee relations and so on.

COST CLASSIFICATIONS (ASSIGNING COSTS TO COST OBJECTS) cost object -

anything for which cost data are desired including products, product lines,
customers, jobs, and organizational subunits.

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DIRECT COST
• a cost that can be easily and conveniently traced to the particular cost
object under consideration.
• For example, if a company is assigning costs to its various regional and
national sales offices, then the salary of the sales manager in its
Tokyo office would be a direct cost of that office.

INDIRECT COST
• a cost that cannot be easily and conveniently traced to the particular
cost object under consideration.
• For example a soup factory may produce dozens of verities of canned
soups. The factory manager's salary would be an indirect cost of a
particular verity such as chicken noodle soup.

COST CLASSIFICATION (DECISION MAKING)

Differential Cost
• A difference in cost between any two alternatives is known as
differential cost. A difference in revenue between any two alternatives
is known as differential revenues.
• Differential cost includes both cost increase (incremental cost) and
cost decrease (decremental cost).
• Differential cost can be either variable or fixed.

OPPORTUNITY COST
• is the potential benefit that is given up when one alternative is
selected over another.

SUNK COST
• a cost that has already been incurred and that cannot be changed by any
decision made now or in future.
• Sunk costs cannot be changed by any decision.
• These are not differential costs and should be ignored in decision
making.

QUALITY COSTS
• refers to all of the costs that are incurred to prevent defects or that
result from defects in products.

Prevention Costs
• support activities whose purpose is to reduce the number of defects.
• Companies employ many techniques to prevent defects for example
statistical process control, quality engineering, training, and a
variety of tools from total quality management (TQM).

Appraisal Costs
• are sometimes called inspection costs, are incurred to identify
defective products before the products are shipped to customers.

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Internal failure Costs
• result from identification of defects before they are shipped to
customers.
• These costs include scrap, rejected products, reworking of defective
units, and downtime caused by quality problem.

External Failure Costs

• When a defective product is delivered to customer, external failure cost
is the result.
• include warranty, repairs and replacements, product recalls, liability
arising from legal actions against a company, and lost sales arising
from a reputation for poor quality.

ILLUSTRATIVE EXERCISES
RELATIONSHIP BETWEEN VARIABLE AND FIXED COST
Allan Company manufactures and sells a single product. A partially
completed schedule of the company’s total and per unit costs over a relevant
range of 60 to 100 units produced and sold each year is given below.
Units Produced and Sold
600 800 1000
Total Costs:
(A) variable cost 1200
(B) fixed cost 6000
(C) total costs

Cost Per Unit:

(D) variable costs
(E) fixed costs

Required: Based on the above data,

1. Complete the schedule by writing the correct amount in blanks.
2. Identify two specific costs that remain constant over the relevant
range.
3. Identify two specific costs that are directly related with
production.
4. Identify the specific cost that is inversely related with
production.
5. Express the cost formula based on the line equation form Y = a +
bX.
6. If the company produces 90 units, then how much is the expected
total costs?

MANUFACTURING VS. NONMANUFACTURING COSTS CLASSIFICATION

Bohol Bikes Co. Ltd. Specializes in manufacturing many different models
of bicycles. Assume that a new model, the Jogger, has been well accepted.
As a result, the company has established a separate manufacturing facility
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to produce these bicycles. The company produces 1,000 bicycles per month.
Giant’s monthly manufacturing cost and other expenses data related to
these bicycles are as follows:
1. Rent on manufacturing equipment (lease cost) P20,000/month.
2. Insurance on manufacturing building P7,500/month.
3. Raw materials (frames, tires, etc.) P800/bicycle.
4. Utility costs for manufacturing facility P10,000/month.
5. Supplies for administrative office P8,000/month.
6. Wages for assembly line workers in manufacturing facility
P300/bicycle.
7. Depreciation on office equipment P6,500/month.
8. Miscellaneous materials (lubricants, solders, etc.) P12.00/bicycle.
9. Property taxes on manufacturing building P24,000/year.
10. Manufacturing supervisor’s salary P30,000/month.
11. Advertising for bicycles P300,000/year.
12. Sales commissions P100/bicycle
13. Depreciation on manufacturing building P15,000/month.

Required:
1. Classify the cost as direct materials, direct labor, manufacturing
overhead and period costs.
2. Compute total manufacturing costs for the month.

HIGH-LOW METHOD
The controller of PATHAYA GENERAL HOSPITAL would like to come up with a
cost formula that links admitting department cost to the number of patients
admitted during the month. The admitting department’s costs and the number
of patients admitted during the past nine months are given in the following
table:
Month Number of Admitting
Patients Department’s
Admitted Cost
April 180 156,000
May 190 152,000
June 170 137,000
July 150 146,000
August 150 143,000
September 110 132,000
October 110 128,000
November 480 725,000
December 160 140,000

Required: Using the high-low method, determine:

1. The variable cost per unit.
2. The annual fixed costs.
3. The admitting department’s cost function.

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 4. Total estimated costs, if number of patients admitted for the month
is 200.

LEAST-SQUARES REGRESSION ANALYSIS

Green Company’s total overhead costs at various levels of activity are
presented below:
Machine Total Overhead
Month Hours Costs
March 5,000 9,700
April 4,000 8,510
May 6,000 10,890
June 7,000 12,080

The breakdown of the overhead costs in April at 4,000 machine-hour level

of activity is as follows:
Supplies (variable) 2,600
Salaries (fixed) 3,000
Utilities (mixed) 2,910
Total P 8,510

Required:
Determine how much of June’s overhead cost of P12,080 consisted of
utilities cost.
1. Using high-low method, determine the cost function for utilities cost.
2. Using high-low method, determine the cost function for total overhead
costs.
3. Using least-squares method, determine the cost function for total
overhead costs.
4. What would be the total overhead costs if operating level is at 450
machine hours?

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