CHAPTER 2 (COST CONCEPTS AND CLASSIFICATION) • Direct labor – the amount paid as wages to those working directly on the

• Cost – is the cash or cash equivalent value sacrificed for goods and services product.
that are expected to bring a current or future benefit to the organization. - Include all labor costs for specific work performed on products that can be
- We say cash equivalent because non-cash assets can be exchanged for the conveniently and economically traced to end products
desired goods or services
- Costs are incurred to produce future benefits in a profit making firm - Payroll related costs, such as payroll taxes, group insurance, sick pay,
- As costs are used up in the production of revenues, they are said to expire vacation and holiday pay, and other fringe benefits can be considered as part
of direct labor costs, but are usually included as factory overhead.
■ Expenses – expired costs
■ Loss – cost that expires without producing any revenue benefit
• Factory Overhead (Manufacturing Overhead/Factory Burden/Indirect
Manufacturing Costs) – a catchall for manufacturing costs that, cannot be
▲ Classification of Costs classified as direct materials or direct labor costs.
• Costs Classified as to Relation to a Product - Varied collection of production-related costs that cannot be practically or
■ Manufacturing costs/product costs conveniently traced directly to end products.
◊ Direct materials
◊ Direct labor ■ Indirect materials and supplies – minor materials and other production
supplies that cannot be conveniently or economically traced to specific
◊ Factory overhead
products
Ex: Nails, rivets, lubricants, and small tools.
■ Non-manufacturing costs/period costs
◊ Marketing or selling expense
■ Indirect labor costs – production related activities that cannot be
◊ General or administrative expense conveniently and economically traced to end products
Ex. Lift-truck driver's wages, maintenance and inspection labor, engineering
• Costs Classified as to Variability labor, machine helpers, and supervisors.
■ Fixed costs
■ Variable costs ■ Other indirect factory costs
■ Mixed costs Ex. Building maintenance, machinery and tool maintenance, property taxes,
property insurance, pension costs, depreciation on plant and equipment, rent
expense, and utility expense.
• Costs Classified as to Relation to Manufacturing Departments
■ Direct departmental charges
■ Indirect departmental charges

• Costs Classified to their Nature as Common or Joint

■ Common costs
▲ Non-Manufacturing Costs/Period Costs
■ Joint cost
• Marketing or selling expenses – all costs necessary to secure customer
orders and get the finished product or service into the hands of the customer.
• Costs Classified as to Relation to an Accounting Period - Since marketing expenses relate to contacting customers and providing for
■ Capital expenditures their needs, these expenses are often referred to as order-getting and order-
■ Revenue expenditures filling costs.
Ex. Advertising, shipping, sales travel, sales commissions, sales salaries, and
expenses associated with finished goods warehouses.
• Costs for Planning, Control, and Analytical Processes
■ Standard costs
• Administrative or general expenses – all executive, organizational, and
■ Opportunity costs clerical expenses that cannot logically be included under either production or
■ Differential cost marketing.
■ Relevant cost Ex. Executive compensation, general accounting secretarial, public relations,
■ Out-of-pocket cost and similar expenses having to do with the overall general administration of
the organization as a whole.
■ Sunk cost
■ Controllable cost
▲ Costs Classified As To Variability
• Fixed cost – items of cost which remain constant in total, irrespective of the
▲ Manufacturing Costs/Product Costs/Inventoriable Costs
volume of production.
• Direct materials – the basic ingredients that are transformed into finished
- Fixed cost are not related to activity within the relevant range.
products through the use of labor and factory overhead in the production
process. - Fixed costs are assignable to departments based on difference allocation
methods.
- Those that can be traced to the finished product can they form part of the
product. Ex. Salaries of production executives, depreciation of equipment computed on
a straight-line basis, periodic rent payments, and insurance.
■ Direct costs – cost of direct materials

■ Committed fixed costs – costs that represent relatively long term

- All manufactured products are made from basic direct materials.
commitments on the part of management as a result of a past decision
- The basic material may be iron ore for steel, sheet steel for automobiles,
Ex. Depreciation on equipment.
flour for bread wood tables and chairs.

■ Managed fixed costs (Discretionary/Programmed/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
Ex. Advertising, research and development and costs of training of employees
■ Graph of Total Fixed Cost ◊ Illustration

Activity Fixed cost per unit Total fixed cost 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
1 1,500 1,500 fee; the variable portion is the P1.50/km driven. If 10,000 km. are driven
2 750 1,500 during the month, the total monthly cost of the delivery truck is P 35,000,
computed as follows:
5 300 1,500

10 150 1,500
Flat fee (fixed portion) 20,000
20 75 1,500 Variable portion - 10,000 km. x P 1.50 15,000
30 50 1,500 Total cost 35,000
- Total fixed cost remains unchanged as activity changes.
- When activity triples, from 10 to 30 units, total fixed cost remains constant ■ Step costs
at P1,500. - The fixed part of step costs changes abruptly at various activity levels
- If activity level is only I unit, then the fixed cost per unit is P1,500. because these costs are acquired in indivisible portions.
- If the activity level is 10 units, then the fixed cost per unit declines to Pl50 - A step cost is similar to a fixed cost within a very small relevant range.
per unit.
- Fixed cost per unit will decrease as we increase the volume or units of Ex. Supervisor’s Salary
production and fixed cost per unit will increase as we decrease the volume of
Assume that one supervisor with a salary of P 30,000 is needed for every 10
production.
workers, then if 15 workers are used supervisors (with salaries of P60,000)
will be needed. If 18 workers are used, still supervisors would be needed. If
• Variable costs – items of cost which vary directly, in total, in relation to the number of workers increases to 22, three supervisors would be needed.
volume of production.
Ex. Direct materials, direct labor, royalties, and commission of salesmen. ◊ Methods of Separating Mixed Cost into Fixed and Variable
Components
■ Graph of Variable Costs  Scattergraph

 High-low Point Method

Month Direct labor hours Cost of electricity

January 28 625

February 24 565
Activity Variable cost per unit Total variable cost
March 30 630
1 100 100
April 33 640
10 100 1,000
May 38 685
20 100 2,000
June 34 640
30 100 3,000
July 35 655
- Total variable cost increases proportionátely with activity. August 40 700
- When activity doubles from 10 to 20 units, total variable cost doubles, from
September 42 715
P1, 000 to P2, 000.
October 47 726
- However, the variable cost per unit remains the same as activity changes.
- The variable cost associated with each unit of activity is P100, whether it is November 43 700
the first unit the fourth, or the tenth. December 32 630
- As activity changes, total variable cost increases or decreases
proportionately with the activity change, but unit variable cost remains the
same Direct labor hours Cost
Highest month (Oct) 47 726
• Mixed cost – items of cost with fixed and variable components. Lowest month (Feb) 24 565
- Mixed costs vary with the level of production, though not in direct relation Difference 23 161
to it, probably because part of the cost is fixed while the rest is variable.

P161
■ Semivariable cost Variable rate per direct labor hour =
23 hours
- The fixed portion of a semi-variable cost usually represents minimum fee for
making a particular item or service available. = P 7/direct labor hour
- The variable portion is the cost charged for actually using the service.
Ex. Cost of electricity where there is a basic minimum charge plus a specified High Low
cost per kilowatt hour above the minimum, cost charged for using a cell phone Total cost of electricity 726 565
under a plan; cost of the plan is fixed and it is for a specified time used, Less: variable proportion
however if the user exceeds the time allowed, then charges will be made on a
per minute basis. (P 7 * 47) 329
(P 7 * 24) ___ 168
Monthly fixed cost
Y= FC + VC or Y = FC + VX
Y = Total cost
V = Variable cost per unit
X = Activity level
VC = Total variable cost
FC = Fixed cost
 Method of Least Square
Equation 1: Y = a + bx
Equation 2: ΣY = na + bΣx
Equation 3: ΣXY = Σxa + bΣx
Direct labor hours Electricity cost
(X)
28 625
397 397
▲ Costs Classified as to Relation to Manufacturing Departments
• 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 indirect benefited from said costs.
▲ Costs Classified to their Nature as Common or Joint
• Common cost – costs of facilities or, services employed in two or more
2 accounting periods, operations, commodities, or services.
- Just like indirect costs, these costs are subject to allocation.
Ex. If two departments are occupying the same building, the depreciation of
2 the building id a comnon cost subject to allocation based on floor area
XY X
(Y) occupied.
17,500 784

24 565 13,560 576 • Joint cost – costs of materials, labor, and overhead incurred in the
manufacture of two or more products at the same time.
30 630 18,900 900
- A major difficulty inherent to joint costs is that they are indivisible and they
33 640 21,120 1,089 are not specifically identifiable with any of the products being simultaneously
38 685 26,030 1,444 produced.
- These costs are also subject to allocation.
34 640 21,760 1,156
Ex. Direct materials, direct labor, and factory overhead cost incurred to
35 655 22,925 1,225 manufacture two or more products up to the point of split-off (or where they
40 700 28,000 1,600 will go separate ways)
42 715 30,030 1,764
▲ Costs Classified as to Relation to an Accounting Period
47 726 34,122 2,209
• Capital expenditure – expenditure intended to benefit more than one
43 700 30,100 1,849
accounting periods and is recorded as an asset.
32 630 20,160 1,024 - The allocation of the cost to the different periods is – depreciation for fixed
426 7,911 284,207 15,620
tangible assets, amortization for intangible assets and depletion for wasting
assets.

By substitution: • Revenue expenditure – expenditure that will benefit current period only
Equation 2: ΣY = na + bΣx and is recorded as an expense.
(7,911 = 12a + b426) 35.5 (426/12)
▲ Costs for Planning, Control and Analytical Processes
Equation 3: ΣXY = Σxa + bΣx2 • Standard costs – predetermined costs for direct materials, direct labor, and
284,207 = 426a +b15,620 factory overhead.
Equation 2 x 35.5 280.840.5 = 426a +b15,123 - They are established by using information accumulated from past experience
and data secured from research studies.
3,366.5 = 0 b 497
- In essence, a standard cost is a budget for the production of one unit of
b = 3,366.5/497
product or service.
b = 6.77
- It is the cost chosen by the managerial accountant to serve as the benchmark
in the budgetary control system.
Substituting the value for Equation 2, we can compute for a as follows
7,911 = 12a + (6.77)(426) • Opportunity cost – the benefit given up when one alternative is chosen over
7,911 = 12a + 2,884 another.
12a = 7,911 – 2,884 - Opportunity costs are not usually recorded in the accounting system.
a = 5,027/12 - However, opportunity costs should be considered when evaluating
alternatives for decision-making.
= 418.92
- If an asset can be used to perfom only one function and cannot be solad or
used in other ways, the opportunity cost of that asset is zero.
Formula using high-low method
Y = a + bx
Ex. Michelle has a part-time job that pays her P1, 000 per week. She would
= 397 + 7x 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 Pl, 000 in lost
Formula using least square method wages will be an opportunity cost of doing so.

Y = a + bx
= 419 + 6.77x • Differential cost – cost that is present under one alternative but is absent in
whole or in part under another alternative.
■ Incremental cost – an increase in cost from one alternative to another
In most cases the amounts derived using high/low point and method of least
square are not the same ■ Decremental cost – a decrease in cost from one alternative to another
 COST FLOW- MANUFACTURING FIRMS
- The accountant's differential cost concept is basically the same as the • Cost Flow – Manufacturing Firms
economist's marginal cost concept.
- In speaking of changes in cost and revenue, the economist employs the terms
marginal cost and marginal revenue.
■ Marginal revenue – revenue that can be obtained from selling one more
unit of product
■ Marginal cost – cost involved in producing one more unit of product
• Cost Flow – Merchandising Firms

- Differential costs can be either fixed or variable.

■ Illustration
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 below. • Cost Flow – Service Firms

- The essential purpose of any organization is to transform inputs into outputs.

The differential revenue is P 300,000, and the differential costs total
P185,000, leaving a positive differential net income of P 115,000 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 cost 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 – cost for which an outlay has already been made and it cannot be
changed by present of future decision
- Since sunk costs cannot be changed by any present or future decision, they
are not differential costs, and therefore they should be used inanalyzing future
courses of action.
- 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.
- A merchandising organization starts with a finished product and markets 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 that reflects the costs involved in transtorming input materials into
finished goods.
- Service organizations are different from manufacturing and merchandising
because they have no inventory of goods for sale.
- Costs are charged to responsibility centers for performance evaluation.
- 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 statements.

■ Illustration
Assume that a firm has just paid P 250,000 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 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
authorize 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.
Ex. 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 costs can be renegotiated, and thus management
can exercise control over the long run.