Week 003

Understanding and
classifying costs
Week 003: Understanding and classifying costs

Cost Control

• To control costs means to understand them.

• Traditional management accounting provides intelligent information to managers in
order to reduce expenses and increased profit.
• Reducing expenses requires thoroughly understanding it first to be controlled and
managed.
Week 003: Understanding and classifying costs

Cost Control

• This orientation had led to the development of stand, albeit, managed and costing
systems, cost-volume-profit analysis, flexible budgeting, segment reporting and
variance analysis, and responsibility accounting.
• To manage cost means to control or reduce it or to justify its priority of incurrence.
The use of the term "costs" here includes costs and expenses.
Week 003: Understanding and classifying costs

Cost Concepts

• To manage costs, it means knowing their nature, behavior and other characteristics.
• At the most basic level, a cost may be defined as the value foregone or sacrifice of
resources for the purpose of achieving some economic benefit which will promote
the profit-making ability of the firm.
Week 003: Understanding and classifying costs

Cost Concepts

• A cost is incurred when a resource is used for some purpose.

• It is also an outlay or expenditure of money to acquire goods and services that assist
in performing operations.
Week 003: Understanding and classifying costs

Cost Concepts

• In managerial accounting, the term cost may be used in different ways because there
are many types of costs that may be classified differently according to the immediate
needs of management.
• For instance, external financial reports require the use of historical cost data
whereas decision making may require current cost data.
Week 003: Understanding and classifying costs

Cost Concepts

Cost Pools
• Cost pools are costs collected into meaningful groups. Cost pools may be classified
1) by type of cost (labor cost in one pool, materials costs in another)
2) by source (department 1, department 2 and so on)
3) by responsibility (manager 1, manager 2 and so on); and many more.
Week 003: Understanding and classifying costs

Cost Concepts

Cost Object
• A cost object is any product, service or organizational unit to which costs are
assigned for some management purpose.
• Products and services are generally cost objects, while manufacturing departments
are considered either cost pools or cost objects, depending on whether
management's main focus is on the costs or the products or for the production
department.
Week 003: Understanding and classifying costs

Cost Concepts

Cost Drivers
• A critical first step for achieving a competitive advantage is to identify the key cost
drivers in a firm or organization.
• A cost driver is any factor that has the effect of changing the level of total cost.
• The management of the key cost drivers is essential for a firm that competes on the
basis of cost leadership.
Week 003: Understanding and classifying costs

Cost Concepts

Cost Assignment and Classification

• Cost assignment is the process of assigning costs to cost pools or from cost pools to
cost objects.
• Cost allocation is the assignment of indirect costs to cost pools.
• Allocation bases are cost drivers used to allocate costs.
Week 003: Understanding and classifying costs

Cost Concepts

Classification of Costs
• Cost classifications are necessary for the development of cost information to serve
the needs of management.
• Understanding these concepts and classifications enables the managerial accountant
to provide appropriate cost data to the managers who need it.
Week 003: Understanding and classifying costs

Cost Concepts: Costs classified by Nature or Management Function

Manufacturing costs
• are all the costs associated with production of goods.
• They are frequently classified as direct materials, direct labor, and factory
overhead.
• Since costs attach to the product or groups of products as they are manufactured,
expenditures, regardless of their nature, usually are capitalized as inventory
assets and do not become "expired costs" or "expenses" until the goods are sold.
Week 003: Understanding and classifying costs

Cost Concepts: Costs classified by Nature or Management Function

Manufacturing costs
• Direct Materials.
• All raw material costs that become an integral part of the finished product
and that can be conveniently and economically assigned to specific units
manufactured.
• Direct labor.
• All labor costs related to time spent on products that can be conveniently and
economically assigned to specific units manufactured.
Week 003: Understanding and classifying costs

Cost Concepts: Costs classified by Nature or Management Function

Manufacturing costs
• Manufacturing overhead.
• the third element of manufacturing cost, includes all costs of manufacturing
except direct materials and direct labor.
• Indirect materials.
• materials include materials and supplies used in the manufacturing
operation that do not become part of the product, such as oil for the
machinery and cleaning fluids for the custodian.
Week 003: Understanding and classifying costs

Cost Concepts: Costs classified by Nature or Management Function

Manufacturing costs
• Manufacturing overhead.
• Indirect labor.
• Labor costs that cannot be identified or traced to specific units
manufactured.
• Other Manufacturing Overhead.
• include overtime premiums and the cost of idle time.
Week 003: Understanding and classifying costs

Cost Concepts: Costs classified by Nature or Management Function

Manufacturing costs
• Manufacturing overhead.
• Nonmanufacturing Costs.
• Nonmanufacturing costs generally include costs related to selling and
other activities not related to the production of goods.
Week 003: Understanding and classifying costs

Cost Concepts: Costs classified by Nature or Management Function

Manufacturing costs
• Manufacturing overhead.
• Marketing costs.
• all costs associated with marketing or selling a product or all costs
incurred by the marketing division from the time the manufacturing
process is completed until the product is delivered to the customer or
all costs necessary to secure customer orders and get the finished
product or service into the hands of the customer.
Week 003: Understanding and classifying costs

Cost Concepts: Costs classified by Nature or Management Function

Manufacturing costs
• Manufacturing overhead.
• General and administrative costs.
• General administrative costs include all executive, organizational and
clerical costs associated with the general management of the
organization rather than with manufacturing, marketing or selling.
Week 003: Understanding and classifying costs

Cost Concepts: Cost classified according to the Timing of Recognition as Expense

Product Costs.
• Product costs include all the costs that are involved in acquiring or making a
product.

Period Costs.
• Period costs are all the costs that are identified with accounting periods and not
included in product costs.
Week 003: Understanding and classifying costs

Cost Concepts: Cost classification for Predicting Cost Behavior

Variable Costs.
• Costs that change directly in proportion to changes in activity (voJume).
• Direct labor and direct materials are examples of variable costs.

Fixed Costs.
• Costs that remain unchanged for a given time period regardless of change in
activity (volume) Rent, insurance on property, maintenance, and repairs of
buildings, and depreciation of factory equipment are examples of fixed costs.
Week 003: Understanding and classifying costs

Cost Concepts: Cost classified by Types of Inventory

Raw Materials Inventory.

• The cost of all raw material and production supplies that have been purchased
but not used at the end of the period.
Work-in-process Inventory.
• The cost associated with goods partially completed at the end of the period.
Finished Good Inventory.
• Cost of completed goods that have not been sold at the end of the period.
Week 003: Understanding and classifying costs

Cost Concepts: Cost classification according to Traceability to Cost Objective

Direct costs (traceable; separable).

• Costs that can be economically traced to a single cost object (i.e. product,
department or unit).
Indirect costs.
• Costs that are not directly traceable to the cost object (i.e. product, department,
etc.)
Week 003: Understanding and classifying costs

Cost Concepts: Cost of classification according to Managerial Influence

Controllable cost.
• Cost that is subject to significant influence by a particular manager within the
time period under consideration.
Noncontrollable cost.
• Cost over which a given manager does not have a significant influence.
Week 003: Understanding and classifying costs

Cost Concepts: Cost Terminologies Used for Planning and Control

Standard Costs.
• A predetermined cost estimate that should be attained; usually. expressed in
terms of costs per unit.
Budgeted Cost.
• Used to represent the expected/planned cost for a given period.
• For example, a company plans to manufacture 1,000 units of product X, which has
a standard cost per unit of P4, would have budgeted cost for the period ofP4,000
for product X.
Week 003: Understanding and classifying costs

Cost Concepts: Cost Terminologies Used for Planning and Control

Absorption Costing.
• A costing method that includes all manufacturing costs - direct materials, direct
labor, and both variable and fixed manufacturing overhead - in the cost of a unit
of product. It is also referred to the full cost method.
Direct Costing.
• A type of product costing where fixed costs are charged against revenue as
incurred and are not assigned to specific units of product manufactured, also
referred to as variable costing.
Week 003: Understanding and classifying costs

Cost Concepts: Cost Terminologies Used for Planning and Control

Information Costs.
• Costs of obtaining information.
Ordering Costs.
• Costs that increase with the number of orders placed for inventory.
Out-of-pocket Costs.
• Costs that must be met with a current expenditure or cash outlay.
Week 003: Understanding and classifying costs

Cost Concepts: Cost classification according to Time-frame Perspective

Committed Cost.
• Cost that is inevitable consequence of a previous commitment.
Discretionary Cost (programmed; managed cost).
• Cost for which the size or the time of incurrence is a matter of choice.
Week 003: Understanding and classifying costs

Cost Concepts: Costs classified according to Time Period for Which the Cost Incurred

Historical costs (past costs).

• Costs that were incurred in a past period.
Future costs.
• Budgeted costs that are expected to be incurred in a future period.
Week 003: Understanding and classifying costs

Cost Concepts: Costs classifications for Decision-making and other Analytical Purposes

Relevant Costs.
• Future costs that are different under one decision alternative than under another
decision alternative.
Incremental Costs.
• The difference in cost between two or more alternatives.
Week 003: Understanding and classifying costs

Cost Concepts: Costs classifications for Decision-making and other Analytical Purposes

Sunk Costs.
• Past costs that have been incurred and are irrelevant to a future decision.
Opportunity Costs.
• The value of the best alternative foregone as the result of selecting a different use
of resource or by choosing a particular strategy.
Week 003: Understanding and classifying costs

Cost Concepts: Costs classifications for Decision-making and other Analytical Purposes

Marginal Costs.
• Costs associated with the next unit or the next project or incremental cost
associated with an additional project as opposed to the next discrete unit.
Value-Added Costs.
• Costs that add value to the product.
Week 003: Understanding and classifying costs

Accountant’s perspective

Capital expenditures vs. Operating expenditures.

• Capital expenditures are outlays normally requiring large amount of money and
resources having a long-term impact to business profitability but are initially
relating to the investing activities of the organization.
• Operating expenditures are outlays or consumption used to directly support the
normal operating activities of the business.
Week 003: Understanding and classifying costs

Accountant’s perspective

Cost vs. Expenses vs. Loss. .

• Costs of goods manufactured are those incurred in producing goods and
resources. Examples are direct materials, direct labor and factory overhead.
• Expenses are those incurred in distributing goods and managing a business.
• Losses do not give any benefit to the business. E.g. loss on sales of equipment,
loss on inventory obsolescence
Week 003: Understanding and classifying costs

Manager’s perspective

Relevant cost vs. Irrelevant cost.

• Costs that are useful in making decisions are relevant costs.
• Those that are not useful are irrelevant. Relevant costs have two characteristics.
• They differ from one alternative to another (i.e., differential costs) and they deal
about the future (i.e., future costs).
Week 003: Understanding and classifying costs

Manager’s perspective

Direct segment cost vs. Indirect segment cost

• Direct departmental costs are those that arc directly identified with the
department, process, segment, or activity. They may be variable or fixed costs.
• Indirect departmental costs are those that are not directly identified with a
department. They are sometimes referred to as "allocated-costs", "common
costs", or plainly "unavoidable costs".
Week 003: Understanding and classifying costs

Manager’s perspective

Avoidable cost vs. Unavoidable cost.

• Avoidable costs are those not incurred once an activity is not performed.
• Unavoidable costs are those that would remain to be incurred regardless of
option a manager chooses.
Week 003: Understanding and classifying costs

Manager’s perspective

Planned cost vs. Actual cost. .

• Planned costs are those that relate to future occurrences and are referred to in
multifarious names such as projected costs, estimated costs, budgeted costs,
applied costs, and standard costs.
• Actual costs, or explicit costs, are those expenditures already incurred and
recorded in the accounting books.
Week 003: Understanding and classifying costs

Manager’s perspective

Sunk cost vs. Future cost.

• Sunk costs are those that have been incurred in the past and can no longer be
changed.
• Future costs are to be incurred in the coming periods. They are relevant and are
of value in making decisions.
Week 003: Understanding and classifying costs

Economist's perspective

Explicit cost vs. Implicit cost.

• Explicit costs are actual costs. They are incurred and recorded in the accounting
books.
• Implicit costs are theoretical costs. They are assumed and are not recognized in
the accounting books. Two good examples of implicit costs are opportunity costs
and imputed costs.
Week 003: Understanding and classifying costs

Economist's perspective

Opportunity cost vs. Imputed cost.

• The benefits given up in favor of another choice are opportunity costs.
• Imputed costs are those costs not incurred but are implied in a given decision.
 -End-

Thank you!