UNIT I

COST CONCEPTS AND CLASSIFICATION

Learning objectives:
At the end of the unit, you should be able to:
1. Differentiate the different cost items with their respective classifications.
2. Separate the variable and fixed component of a mixed cost applying the high-low method.

COSTS (object, product, project or service) – represent the cash or cash equivalent of resources used
in acquiring the goods, manufacturing a product and performing a function.
- It also includes the cost of distributing the products or services to the ultimate consumers.
- The cash equivalent is used because non-cash assets can be exchanged for the desired goods
and services.

I. Product Cost
- Manufacturing costs which include the sum of the inputs or resources used in the
production conversion of raw materials into finished product.
- Otherwise referred to as inventoriable cost as the resources enter the Work in Process
account.
- They include costs of materials, labor and overhead.
 The accumulated cost of materials, labor and overhead, called product costs, is later
reported in the Income Statement as expense under the classification costs of goods
sold, when the units are sold.
Note: A manufacturing company maintains three inventory accounts.
- Raw materials inventory, work in process and finished goods.

Product costs of completed units – reported in the Finished goods inventory account.
Product of units partially completed – work in process inventory.
Raw materials account – accumulates the cost of direct and indirect materials used in
production.

A merchandising company or retailing company ( company engaged in buying

goods ready for sale), product costs include the purchase price of goods bought for
resale plus the transportation costs and other direct costs incurred in bringing the
goods to the place of buyer.
Construction company – product costs include the costs of construction
materials, labor of carpenters and overhead incurred in construction like power, light
and water, insurance, hospitalization and other health benefits for workers,
maintenance of construction equipment, compensation of foremen, cost of temporary
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house for the workers and for construction materials, depreciation of equipment,
rentals and other expenses incurred in the construction site.
A service organization – product costs are classified either as direct or indirect
costs. Their inventory accounts are usually for supplies like office supplies for
accounting firms or law firms and medical supplies for hospitals and medical clinics.
The most significant portion of their costs is labor because the workers utilized
their own efforts in delivering the service.
Elements of Product costs : Manufacturing Company
1. Materials: Include the raw materials and other factory supplies used in the
manufacturing operation.

They are further classified as:

(a) Direct materials – materials traceable to the product being produced.
e.g. lumber in the manufacture of furniture;
galvanized iron and steel – jeepneys and trucks
leather – bags, belts, wallets and shoes
fabrics – shirts, dresses, coats, and other related gents and ladies apparel.
Flour, butter, sugar – bread and other pastries and many more.

(b) Indirect materials - not directly included in or not a significant part of the product.
 Operating, janitorial and factory supplies used in the factory such as nails,
screws, washers, glue, sand paper, lubricating oil, grease, cleaning materials
and other materials needed to maintain the working area and plant equipment
in a usable and safe condition.

2. Labor – compensation and benefits paid to those who physically work on the conversion of
raw materials into finished product and are easily traceable to specific process, job or job
order.
-represents the compensation and other benefits paid to the workers in the factory.
(a) Direct labor - include basic pay, cost of living allowance, 13th month pay and cash
equivalents of non-cash incentives given on a regular basis.
(b) Indirect labor – wages of personnel other than the direct laborers, which are
necessary to the manufacturing process or service but are not directly related to the
actual conversion of raw materials into finished product.
- Include supervisor’s fee, wages paid to other workers such as janitors,
inventory control clerks, guards, and other personnel in the factory,
employee benefits such as employer’s share in SSS, Philhealth and Pag –ibig,
vacation and holiday pay, health insurance of workers, overtime and night
premium, costs of housing and accommodation for stay-in workers.

Direct materials and direct labor – prime costs.

3. Manufacturing overhead – indirect product cost and includes production costs other
than direct materials and direct labor. They include:
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a) Factory supplies - oil and other cleaning materials used in the factory.
b) Wages of supervisors, factory maintenance personnel, raw materials
handlers, and security officers stationed in the factory premises.
c) Depreciation of factory plant and equipment.
d) Insurance and property taxes on factory plant and equipment.
e) Maintenance and repairs on factory plant and equipment.
f) Power, light and water.
g) Telephone and mailing costs.
h) Costs of regulatory compliance such as meeting factory safety requirements
and disposal of waste materials.
Conversion costs – direct labor and factory overhead- used to convert raw
materials into finished goods.
II. Period Costs – operating expenses that are associated with time periods, rather than with the
production of goods and services.
- charged directly to the expense accounts on the assumption that their benefit is
recognized entirely in the period when the cost is incurred.
- they are non manufacturing costs and non inventoriable costs.
- include selling and marketing costs; distribution costs, administrative costs.

III. Direct and Indirect Costs

Direct costs – obviously and physically traced to a manufacturing process, job or order, business
unit, segment or department. Costs to run a business unit
Indirect Costs – overhead costs – process of production.

IV. Common Costs and Joint Costs

Common costs – mutually beneficial costs, costs of facilities or services shared by two or more
Departments or operations.
V. OTHER COSTS CLASSIFICATIONS
a. Opportunity Costs and sunk cost
b. Committed costs and Discretionary Costs
c. Controllable and non-controllable costs
d. Out of the pocket costs and Budgeted Costs
e. Capital expenditures and revenue expenditures
VI. Fixed and variable costs
Fixed costs - Fixed costs are constant in total within the relevant range of activity but
variable on a per unit basis. As the activity level increases or decreases, total fixed
costs remain constant but unit cost declines or goes up.
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Relevant range – limited range of activity within which expenditures can be

accurately classified as fixed cost or variable or the range over which an assumed
cost relationship is valid for the normal operations of a firm.
Mixed costs or semi-variable costs – costs that have both fixed and variable component
like heat, light and water.

REVIEW EXERCISES: COST CLASSIFICATION

I. Before each account title, indicate FC for Factory cost; SE for Selling Expense; GE for general expense
or “X “ for other classifications:

_________ 1. Indirect materials used ___________16. Bond interest expense

_________ 2. Delivery truck ___________ 17. Controller’s salary
_________ 3. Uncollectible accounts ___________ 18. Depreciation-computer at store
_________ 4. Uniform subsidy-office staff ___________ 19. Depreciation – office equipment
_________ 5. Advertising expense ___________ 20. Direct labor
_________ 6. Wages of factory workers ___________ 21. Fuel for factory equipment
_________7. Office salaries expense ___________ 22. Insurance for salesmen
_________ 8. Factory insurance ___________ 23. Insurance –factory building
_________ 9. Salesmen’s commission ___________ 24. Office supplies
_________ 10. Transportation-in ___________ 25. Packaging supplies used
_________ 11. Heat, light and power ___________ 26. Product samples
_________12. Amortization of Patent ___________ 27. Royalties expense
_________ 13. Supervisors’ salaries ___________ 28. Transportation-out
_________ 14. Real property tax ___________ 29. Transportation-salesmen
_________ 15. Office rent ___________ 30. Utilities - store
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