Chapter 1- Introduction to Cost Accounting, Cost Concepts and Classifications, and Cost

Accounting Cycle
Learning Objectives:
• State the scope and primary objectives of cost accounting;
• Differentiate cost accounting from financial and managerial accounting;
• Explain the different costing methods, techniques, and cost accumulation systems;
• Define terms useful in introducing cost accounting system; and
• Distinguish between job order costing and process costing.

I. INTRODUCTION TO COST ACCOUNTING:

Accounting as defined by American Accounting Association Definition is a systematic
process of analysis, recording, classifying, summarizing, and reporting financial transactions and
events and interpreting the results thereof. Accounting is a very broad discipline as it encompasses
financial accounting, management accounting, cost accounting, and finance and taxation.
Cost accounting is the branch of managerial accounting that deals with the determination
and accumulation of cost of a product or activity for financial reporting and decision making
purposes. Costing is a systematic procedure for determining the unit cost of output produced,
activities or services rendered. Management accounting employs cost accounting for planning,
control, and decision – making hence, there is an inevitable overlap between the two.

Cost Accounting Compared to Financial and Managerial Accounting

Financial accounting is the branch of accounting that deals with the accumulation and
preparation of financial data for the investors, creditors, regulators and other external users.
Because financial accounting is designed to meet the needs of the external users, it is required to
comply with the Philippines Financial Reporting Standards ( PFRS ).
On the other hand, management accounting is the branch of accounting that involves the
process of accumulating, summarizing, and interpreting economic data about the business
primarily for management and other internal users. It is not required to adhere to the PFRS when
providing information to management for internal use. Management accounting has a subset called
cost accounting that provides product costing information that is necessary for managers to make
their decisions.

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 Cost accounting is a branch of managerial accounting that focuses on the flow of cost
of the product and services and development of the systems relating to the cost determination. It
supplements the financial accounting by proving cost date and other relevant information
necessary to accomplish its objectives.

The following summarizes the main differences between cost accounting and financial
accounting:
FINANCIAL ACCOUNTING COST ACCOUNTING MANAGEMENT ACCOUNTING
1. Nature Financial Accounting deals Cost Accounting deals with Management accounting deals with
with recording, classifying, recording, classifying, the collection, analysis, and
summarizing and interpreting summarizing and interpreting the interpretation of information to
in monetary terms, the materials, labor and overhead assist management in their
transactions and events carried cost incurred in manufacturing decision-making and to conduct the
out by an organization. and selling the product, activity business more effectively and
or service. efficiently.
2. Purpose Financial Accounting leads to Cost Accounting leads to the Management Accounting provides
the preparation of the major development of cost of a proud, information to management for
financial statements in activity or service, indicating planning, controlling and decision-
accordance with PFRS. It aims profitability of each product, making. It is concerned about
to provide financial activity, or service when needed. providing financial and non-
information mainly to external It aims to provide information to financial information to
users. management for planning and management in order to manage the
control and decision-making. business effectively and efficiently
and to perform key business
decisions and policies.
3. Primary users External users such as Internal users such as managers. Internal users such as managers.
creditors, shareholders,
investors and regulatory
bodies.
4. Accounting system Double entry system is used May not be based in double entry May not be based in double entry
for recording, classifying and system. system.
summarizing transactions and
events.
5. Accounting PFRS are followed in No specific accounting principles No specific accounting principles
principles recording, measuring and are required because information are required because information is
presenting the financial is mainly provided only to mainly provided only to internal
information. internal users for planning and users for planning and control and
control and decision-making. decision-making

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 6. Report timing Financial statements and Cost date provides information Reports are prepared as often as
reports are generally prepared more frequently. However, no needed by the managers for
for a period of one year, but specific period covered is planning and decision making.
can also be prepared at regular required for cost accounting Management is concerned about
intervals such as semi- reports. It depends on the needs timeliness of the information. It
annually or quarterly. of the users for purposes of cannot wait until tomorrow for the
planning, control, cost information that is required for
determination and decision- today’s decision.
making.

Objectives of Cost Accounting

Cost accounting has a number of objectives and the most important objectives are the following:
1. To determine the product cost.
Cost accounting involves the gathering, and allocation of expenses between
manufacturing and non – manufacturing activities. The cost of goods manufactured is
ascertained through various costing techniques such as actual or historical costing, standard
costing, and normal costing.

2. To determine the selling price.

Cost accounting provides necessary information about the cost of a product as well
as the cost incurred at every stage of production. The cost of the product is an important
factor in deciding its selling price. Although other factors are taken into consideration such
as the condition of the market, area of distribution or volume of sales, the cost of a product
plays a major role in fixing the selling price.

3. To control cost.
Cost accounting helps management to control cost through various techniques such
as budgetary control, standard costing and inventory management control in order to
monitor the company’s operation and determine whether the objectives identified in the
planning process are efficiently accomplished.

4. To facilitate the preparation of financial statements and other reports.

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 Cost Accounting provides timely information necessary for the preparation of the
financial statements and other reports. In order to manage the business and determine its
overall operating efficiency, it is essential for management to review the cost date relating
to procurement, production, sales and operating result of the business. Financial statements
are generally prepared once a year since the value of actual closing inventories is usually
available at the end of the year. However, because cost accounting provides production
report and value of closing stock periodically, it helps in the preparation of the financial
statements at shorter intervals.

5. To provide information for decision-making.

Cost accounting provides information for managerial decision in formulating
business policies such as make or buy decision, whether to close or continue the operation
at a loss, determining cost-volume-profit relationship, etc. It is also use by management for
the, to determine that amount that each product earns and decide whether to eliminate such
product line or not.

Scope of Cost Accounting

1. Costing
Costing involves the collection and classification of costs according to various
elements and proper allocation of the expenses to either product or activity. The main
purpose of costing is the determination of the cost of products, activities, or services.

2. Budgeting
Budgeting involves the preparation of the company’s plan of operation and
activities, and expressing it in financial terms.

3. Cost Control
Cost control involves the analysis of the cost and comparison with the
predetermined standards set by the company. Any variances are used as gauge to measure
company’s operating efficiency.

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Components of Cost Accounting
Cost of accounting has five components with its subset namely:
I. Costing Method
a. Actual or historical
b. Standard
c. Normal
II. Costing Technique
a. Absorption or Full Costing
b. Variable or Direct Costing
c. Activity- Based Costing
III. Cost Accumulation
a. Job Order Costing
b. Process Costing
c. Backflush Costing
IV. Cost Flow Assumption
a. Specific Identification
b. First in First out (FIFO)
c. Last in First out (LIFO)
d. Average Method
V. Inventory System
a. Perpetual Inventory System
b. Periodic Inventory System

COSTING METHOD
The three costing methods that influence the amount of cost to be assigned to the product are the
following:
1. Actual or historical costing refers to the costing of a product based on the actual historical
costs after they are incurred.

2. Standard costing involves the estimation and setting of pre-determined standard by

management before the new accounting period begins

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Standard costs are used to determine the cost of a product activity, or service, and then compared
with the actual cost to determine the extent of the variances for investigations and management
actions.
3. Normal costing refers to the setting of the cost of a product based on actual costs except
for the overhead which is based on pre-determined rate.
The overhead application rate is charged per unit of activity during the given period.
The summary of the three costing methods is presented below:
Actual Standard Normal
Direct materials Actual Standard Actual
( actual price X actual ( standard price X standard ( actual price X actual
quantity of input used ) quantity of input allowed quantity of input used )
for actual output achieved
)
Direct labor Actual Standard Actual
( actual price X actual ( standard price X standard ( actual price X actual
quantity of input used ) quantity of input allowed quantity of input used )
for actual output achieved
)
Overhead Actual Standard Budget
( actual OH rate X actual ( standard OH rate X ( predetermined OH rate X
quantity of cost allocation standard quantity of cost actual quantity of cost
based used ) allocation base allowed for allocation base used )
actual output achieved )

COSTING TECHNIQUE
There are three costing techniques that are commonly used in cost accounting:
1. Absorption or full costing is traditional costing technique where all manufacturing costs,
whether fixed or variable, are treated as product costs.

2. Variable or direct costing refers to the costing technique were all variable manufacturing costs
(direct materials, direct labor and variable factory overhead) are considered product costs
while fixed factory overhead cost is considered as period cost.

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3. Activity-based costing (ABC) is a costing technique which assumes that cost objects consume
activities. It assigns overhead costs to the activities that are real cause of the overhead and
subsequently assigns the cost of those activities only to the products that demand such
activities.

COST ACCUMULATION SYSTEM

The following are the most popular cost accumulation systems:

1. Job order costing is It is a product costing system used by companies making one—of-a kind
or special-order products. The cost of a product is tracked by individual job orders.

2. Process costing is used when homogenous or very similar products are produced in large
volumes. Manufacturing cost incurred are allocated to the proper functions or departments
within the process, rather than to specific products or job orders.

3. Backflush costing focuses mainly on the output of the business and then works backwards to
allocate the product cost between cost of goods sold and inventories. This costing was
developed for just-in-time operations.

COST FLOW ASSUMPTION

The following are the common inventory cost flow assumptions in cost accounting:
1. Specific Identification is typical for products that can be clearly differentiated, have high value
and low sales volume. When items are sold, the actual cost of the item is determined and
recognized as cost of goods sold.

2. First in First Out (FIFO) is a cost flow assumption where the goods which were purchased
first are assumed to have been sold first, thus, the ending inventory is comprised of items from
the most recent purchases.

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3. Last-in, First-out (LIFO) is based on the assumption that the latest items purchased are sold
first, leaving the oldest items in the ending inventory. It is not permitted in the Philippines.

4. Average Method is used when same cost is applied to all units in the inventory. The weighted-
average unit cost is determined by dividing the cost of goods available for sale by the number
of units available for sale. At the end of the accounting period, the remaining units on hand
are then multiplied by the weighted average price per unit to determine cost of ending
inventory.

INVENTORY SYSTEM
The two types of inventory system are:
1. Perpetual inventory system. Under this system, the purchase of direct and indirect materials
is recorded in an account “Inventory”. The “inventory” account is updated immediately after
every purchase and sale based on the stock ledger card that is used to control the inventory
quantities.

2. Periodic inventory system. Under this system, the purchase of direct and indirect materials is
recorded in an account “Purchases”. Under this method, the cost of materials is not directly
determined. It is indirectly computed by deducting the remaining inventory on hand from the
total available for use (materials beginning plus net purchases).

COST, COST OBJECT, COST CENTER AND COST UNIT

Cost is the cash or cash equivalent value sacrificed for goods and services that are
expected to bring current or future benefit to the organization.
A cost object is anything for which cost are measured separately. Cost center represents
a location, division, segment or area of activity for which costs may be ascertained for purposes of
controlling costs.
Cost unit is a unit of product, service or activity for which cost may be ascertained or
expressed.

II. CLASSIFICATION AND PURPOSES OF COST

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Cost classification refers to the process of grouping cost according to their common characteristics
or features. While cost classification is determined for planning and control, it is also performed
to obtain proper matching of cost and benefits on the income statement.
1. Cost Classified as to relation to the product
A. Manufacturing or product costs
▪ Direct Materials
▪ Direct Labor
▪ Factory Overhead
B. Non-manufacturing or period costs
▪ Marketing or selling expense
▪ General or administrative expense

2. Cost Classified as to Variability

A. Variable Cost
B. Fixed Cost
C. Mixed Cost

3. Cost Classified as to Controllability

A. Controllable
B. Non- controllable

4. Cost Classified as to time period

A. Historical
B. Predetermined
C. Standard
D. Estimated

5. Cost for planning, control and analytical processes

A. Standard
B. Differential
C. Opportunity

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 D. Relevant
E. Out of pocket cost
F. Sunk

Manufacturing or product costs

Direct Materials
Materials are integral part of a finished product or output. Direct materials are materials that
become part of a finished product and can be conveniently and economically traced to the finished
products.
Examples are iron ore for steel, flour for bread, wood for table and chairs, and cloth to produce a
shirt.

Direct Labor
Labor represents the amount paid for the salaries and wages of the employees for their
services. Direct Labor costs include all labor costs for specific work performed on products that
can be conveniently and economically traced to end products.
Examples are salary of machine operators, salary of employee cutting woo
Factory Overhead
Factory overhead costs are varied collection of product-related costs that cannot be
practically or conveniently traced directly to end products. These include manufacturing costs that
cannot be classified as either direct materials or direct labor costs.
Examples are:
Indirect materials: nails, rivets, lubricants, and small tools
Indirect labor: Salary of supervisor, inspector, machine helpers, and maintenance workers
Other Costs: Building maintenance, factory utilities expense, machinery and tool
maintenance, factory taxes and insurance, depreciation of factory building, plant and equipment,
factory rental expense, and other indirect factory costs.

Non-manufacturing or period costs

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Marketing or selling expense
It includes all costs necessary to secure customer orders and get the finished product or
service into the hands of the customer.
Examples are advertising, shipping, sales travel, sales commission, sales salaries, and other
expenses associated with selling.

General or administrative expense

It includes all executive, organizational, and clerical expenses that cannot be included under
either production or marketing.
Examples are executive compensation, general accounting, secretarial, public relations, and
similar expenses having to do with the general administration of the organization as a whole.

Cost Classified as to Variability

Variable Costs
These are items of cost that vary directly, in total, in relation to volume of production. Cost
per unit is constant regardless of the change in activity level. Examples are direct materials and
direct labor.

Fixed Costs
These are items of cost which remain constant in total, irrespective of the volume of
production. Cost per unit is inversely proportional to the activity level. As activity level increases,
fixed cost per unit decreases, and vice versa. Examples of these costs are salaries of production
executives, depreciation of equipment computed on a straight line basis, periodic rent and
insurance payment.

Mixed Cost
These are items of costs with fixed and variable components. Example includes utilities
where there is a fixed charge for the minimum rate and variable charge per unit for actual excess
usage.

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Cost Classified as to Controllability
• Controllable cost. These costs are subject to the discretion of a manager or can be controlled
to keep within pre-defined limits.
• Noncontrollable cost. These costs are outside the control of a manager or cannot be
influenced at a given level of managerial supervision.

Cost Classified as to time period

• Historical cost is the actual costs of acquiring an asset or producing product or services.
• Predetermined cost for a product is computed in advance of production, on the basis of a
specification of all the factors affecting cost and cost data. Predetermined cost may be
either standard or estimated.
• Standard cost is a predetermined cost established by management at the beginning of the
accounting period to control costs and measure overall efficiency and productivity.
Standard cost is associated either the manufacturing of the product hence, standard cost is
determined for each element of cost (materials, labor and manufacturing overhead). At the
end of the period, standard costs are compared with the actual costs to determine any
variances. For proper cost control, the causes of these variances are analyzed and
investigated.
• Estimated cost refers to the cost of a particular product or activity that is developed before
the actual operations or before customer orders are accepted. Estimated cost is determined
in reference to the activity level of the plant. It is deemed to be less accurate than standard
cost.

Cost for planning, control and analytical processes

• Standard Costs are predetermined costs for direct materials, direct labor and factory
overhead. They are established by using information accumulated from past experience
and data secured form research studies.
• Differential Cost is the cost that is present under one alternative but is absent in whole or
in part under another alternative.
• Relevant Costs- are those that are relevant for different alternatives being considered.

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 • Opportunity Cost is the value of the alternative foregone by adopting or pursuing a
particular strategy or certain action.
• Sunk costs are historical costs that were incurred in the past and are not relevant to the
particular decision-making problem being considered.
• Out of pocket cost requires the payment of money (or other assets) as a result of their
incurrence.

II. COST ACCOUNTING CYCLE

THE MANUFACTURING PROCESS

Manufacturing process begins from the procurement of raw materials up to the
processing of those materials (where additional costs are incurred) to prepare them for sale.
Manufacturing organizations have three types of inventories that are presented in the
statement of financial position. Proper accounting of cost according to these three classifications
is important for both internal and external reporting purposes.
Classification of Inventory Accounts
1. Raw materials Inventory. This is used to account for direct and indirect materials purchased
from suppliers that will be used in the production process. This account is made up of
balances of materials and supplies on hand.
2. Work in process Inventory. This pertains to the cost of uncompleted job orders or process
at the end of the period. This account reflects the cost of direct materials, direct labor and
factory overhead incurred relating to incomplete or unfinished product.
3. Finished goods Inventory. This account used to accumulate the manufacturing costs
incurred relating to a finished product that is ready for sale.

Summary of Journal Entries in Cost Accounting Cycle:

Transaction Journal Entries
(1) Purchase of direct and indirect materials Raw Materials Inventory xxx
Accounts Payable xxx

Return of materials to suppliers Accounts Payable xxx

Raw Materials Inventory xxx

(2) Incurrence of direct and indirect materials Work in Process Inventory xxx
to production Factory Overhead Control xxx

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 Raw Materials Inventory xxx

Return of unused materials to storeroom Raw Materials Inventory xxx

Work in Process Inventory xxx

(3) Incurrence or accrual of payroll Payroll xxx

Withholding taxes payable xxx
SSS contributions payable xxx
Phil health contributions payable xxx
HDMF contributions payable xxx
Accrued salaries xxx

Payment of payroll Accrued salaries xxx

Cash xxx

Accrual of employer's share in various Factory overhead control xxx

contributions Selling expenses xxx
Administrative expenses xxx
SSS contributions payable xxx
Phil health contributions payable xxx
EC contributions payable xxx
HDMF contributions payable xxx

(4) Incurrence of manufacturing overhead or Factory overhead control xxx

indirect resources Specific asset or liability accounts xxx

(5) Application of factory overhead to Work in Process xxx

work in process Applied Factory Overhead xxx

(6) Incurrence of non- manufacturing expenses Selling or administrative expenses xxx

Specific asset or liability accounts xxx

(7) Transfer of completed jobs to finished goods Finished Goods xxx

Work in Process xxx

(8) Sale of finished goods Cash or Accounts Receivable xxx

Sales xxx

(9) Transfer of finished goods to cost of goods sold Cost of Goods Sold xxx
Finished Goods xxx

Manufacturing Cost Flow Basic Concepts

Product Costing, inventory valuation, and financial reporting depend on a defined,
structured flow of manufacturing costs. Problem below summarizes the entire cost-flow process
Brave Company contained the following account balances at the beginning of 2018:

Cash 150,000 Accounts Payable 150,000

Accounts Receivable 60,000 Accrued Salaries 8,000
Finished Goods 55,000 Common Stock 145,000
Work in Process 20,000 Retained Earnings 32,000

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 Materials 50,000

During January 2021, the following transactions were completed:

1. Materials purchased on account, P250,000.
2. Factory overhead incurred on account, P37,800.
3. Payroll for the period consists of direct labor- P140,000; indirect labor- P30,000; sales
salaries- P25,000, and administrative salaries- P15,000. Deductions from payroll were as
follows: Withholding taxes- P18,520; SSS Premiums- P8,400; Phil health Contributions-
P1,125; and Pag-ibig Fund Contributions- P6,300.
4. P175,000 of payroll was paid.
5. Computation of payroll tax is as follows:
Factory Selling Administrative
SSS Premium 8,500 1,250 750
Phil health 600 375 150
Pag-ibig Fund 5,100 750 450

6. Materials issued was P240,000 inclusive of indirect materials of P30,000.

7. Factory overhead was charged to production at 80% of direct labor cost.
8. Ending work in process was P70,000.
9. The product was sold account at 40%mark up on cost. Ending Finished goods was P67,000.
10. Cash collected from customers, P415,000.
11. Payment of accounts payable amounted to P240,000.

Required - Prepare the following for January 31, 2021.

a. Journal Entries
b. Cost of Goods Sold Statement
c. Income Statement
d. Statement of Financial Position

Journal Entries

1 Materials 250,000 6 Work in Process 210,000

Factory Overhead
Accounts Payable 250,000 30,000
Control
* to record purchase of raw materials on account Materials 240,000

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 *to record issuance of materials
2 Factory Overhead Control 37,800
Accounts Payable 37,800 7 Work in Process 112,000
*to record incurrence of factory overhead Factory Overhead Applied 112,000
*to record application of factory overhead
3 210,000
Payroll
Withholding Tax Payable 18,520 8 Finished Goods 412,000
SSS Premiums Payable 8,400 Work in Process 412,000
Phil health Cont. Payable 1,125 *to record transfer of cost of goods manufactured into
Pag-ibig Cont. Payable 6,300 Finished Goods
Accrued Salaries 175,655
*to record accrual of payroll for the month 9 Accounts Receivable 560,000
Sales 56,000
Work in Process 140,000 *to record sales
Factory Overhead Control 30,000
Selling Expenses 25,000 Cost of Goods Sold 400,000
Administrative Expenses 15,000 Finished Goods 400,000
Payroll 210,000 *to record the cost of goods sold
*to record distribution of payroll
10 Cash
4 Accrued Salaries 175,000 Accounts Receivable 415,000
Cash 175,000 *to record collection
*to record payment of payroll for the month
11 Accounts Payable 240,000
5 Factory Overhead Control 14,200 Cash 240,000
Selling Expenses 2,375 *to record payment
Administrative Expenses 1,350
SSS Premiums Payable 10,500
Philhealth Cont. Payable 1,125
Pag-ibig Cont. Payable 6,300
*to accrue the employer's contribution

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The T- Accounts for the transactions are presented below:
Cash Accounts Payable Common Stock
beg 150,000 150,000 beg 145,000
10 415,000 175,000 4 250,000 1

240,000 11 11 240,000 37,800 2

565,000 415,000 240,000 437,800 Retained Earnings
end 150,000 197,800 32,000 beg
116,275 NI
Accounts Receivable Accrued Salaries 148,275 end
beg 60,000 8,000 beg
9 560,000 415,000 4 175,000 175,655 3
620,000 415,000 175,000 183,655 Sales
end 205,000 8,655 end 560,000 9

Finished Goods Inventory Withholding tax Payable

55,000 - beg Selling Expenses
8 412,000 400,000 18,520 3 3 25,000
467,000 400,000 18,520 end 5 2,375
end 67,000 end 27,375

SSS Premium Contributions Payable

Work in Process Inventory - beg Administrative Expenses
beg 20,000 8,400 3 3 15,000
4 140,000 412,000 8 10,500 5 5 1,350
6 210,000 18,900 end end 43,725
7 112,000
482,000 412,000
end 70,000 Philhealth Contributions Payable Factory Overhead Control
- beg 8 37,800
Raw Materials Inventory 1,125 3 3 30,000
beg 50,000 1,125 5 5 14,200
1 250,000 240,000 6 2,250 end 6 30,000
300,000 240,000 end 112,000
end 60,000 Pag-ibig FundPayable
- beg
6,300 3 Factory Overhead Applied
6,300 5 112,000 7
12,600 end 112,000

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 Brave Company Brave Company
Cost of Goods Sold Statement Statement of Financial Position
January 30, 2021 January 30, 2021

ASSETS
Raw Materials, beginning 50,000 Cash 150,000
Add: Purchases 250,000 Accounts Receivable 205,000
Materials Available for Use 300,000 Finished Goods Inventory 67,000
Less: Ending Materials 60,000 Work in Process Inventory 70,000
Indirect Materials 30,000 Raw Materials Inventory 60,000
Direct Materials Used 210,000 TOTAL ASSETS 552,000
Direct Labor 140,000
Factory Overhead 112,000
Total Manufacturing Costs 462,000 LIABILITIES AND CAPITAL
Add: Work in Process, beg 20,000 Accounts Payable 22,800
Cost of Goods Put into
Process 482,000 Accrued Salaries 8,655
Less: Work in Process, end 70,000 Withholding Tax Payable 18,520
Cost of Goods Manufactured 412,000 SSS Prem. Cont. Payable 18,900
Add: Finished Goods, beg 55,000 Philhealth Cont. Payable 2,250
Cost of Goods Available for
Sale 467,000 Pag-ibig Cont. Payable 12,600
Less: Finished Goods, end 67,000 Total Liabilities 83,725
Cost of Goods Sold 400,000
Common Stock 320,000
Brave Company Retained Earnings 148,275
Income Statement Total Capital 468,275
January 30, 2018
Total Liabilities & Capital 552,000
Sales 560,000
Cost of Goods Sold 400,000
Gross Profit 160,000
Expenses 43,725
Net Income 116,275

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