COST CONCEPTS, CLASSIFICATION AND ANALYSIS

Albert A. Victoria

COST - the sacrifices made in order to achieve the objectives.

TYPES OF COST

As to Financial Statement Presentation

1. Cost of Sales
A. Merchandising. Merchandise Inventory -units purchased with the intention of re-selling with little or no alteration The
cost includes the Purchase Price (PP) + Directly Attributable Costs (DACs)
B. Manufacturing

i. Direct Materials (DM) - include those items that become an integral part of a finished product and can be
conveniently traced into it. The cost includes PP + DACs

ii. Direct Labor (DL) - consists of those labor costs that can be easily traced to the creation of product. Also called
touch labor Cost includes Salary and other benefits given like SSS Phil health, etc.

iii. Manufacturing Overhead (MO): all other product costs not classified as DM or DL

a. Indirect materials - materials used to support the production process. They too costly and inconvenient to
trace such small costs to the individual units that are produced (Examples: lubricants and cleaning supplies
used in the automobile assembly plant)

b. Indirect Labor - wages paid to employees who are not directly involved in the production work
(Examples; maintenance workers, janitors, and security guard):

Practice Exercise:
Identify the following costs as direct materials (DM), direct labor (DL), or factory overhead (FO) for a baseball glove
manufacturer.
a. Leather used to make a baseball glove
b. Coolants for machines that sew baseball gloves
c. Wages of assembly line employees
d. Ink used to print a player’s autograph on a baseball glove

a. DM b. FO c. DL d. FO

C. Special Classification
 Prime Cost = DM + DL
 Conversion Cost = DL + MO

Practice Exercise:
Identify the following costs as a prime cost (P), conversion cost (C), or both (B) for a baseball glove manufacturer.
a. Leather used to make a baseball glove
b. Coolants for machines that sew baseball gloves
c. Wages of assembly line employees
d. Ink used to print a player’s autograph on a baseball glove

a. P b. C c. B d. C

2. Operating Expenses (Cost to Sell)

A. Selling Expenses from the time the product is being offered for sale up to the time the product is delivered including
post-sale services.
 B. General and Administrative - general administrative and management of the company.

3.
Finance Costs

As to Purpose:
Product versus Period depending on the costing method (throughput, variable and absorption costing)

1. Product Cost (Inventoriable)- are matched with units of product and are recognized as an expensed on the income statement only
when the units are sold. Until that time, product cost are considered to be assets and are recognized on the balance sheet as
inventory.
2. Period Cost (Non-inventoriable) - are expensed on the income statement in the period in which they incurred.

Practice Exercise:
Identify the following costs as a product cost or a period cost for a baseball glove manufacturer.
a. Leather used to make a baseball glove
b. Cost of endorsement from a professional baseball player
c. Office supplies used at the company headquarters
d. Ink used to print a player’s autograph on the baseball glove

a. Product cost b. Period cost c. Period cost d. Product cost

As to Traceability:
Direct or indirect depending on the Cost Object–anything that will focus the cost information

1. Direct Costs - physically and easily traceable to the cost object under consideration and material in costs. .
Costs Tracing -the process of identifying direct costs
2. Indirect Costs - is a costs that cannot be conveniently traced to the costs object.
Cost Allocation-the process of incorporating (including/adding) indirect costs to the costs object.
Cost Assignment - includes tracing and allocating.
As to Behavior:
Variable or Fixed depending on the cost driver and relevant range.
Cost Driver (Activity Based) - those that causes the incurrence of costs
Relevant Range - the level of activity wherein the classification of costs is valid.

1. Variable Costs - changes in total in direct proportion to changes in the level of activity (Constant per unit but varies in total)
a. Pure or Real - directly proportionate to the level of activity based
b. Step - increase in small steps (small chunks)
2. Fixed Costs - total does not change with changes in the volume of activity Constant in total but varies per unit)
a. Discretionary (optional) – the result of the management decision to spend a particular amount of money for some purpose
b. Committed - cannot be significantly reduced even for short period of time without making fundamental changes
3. Mixed Costs -
a. Contains both variable and fixed costs elements
b. Expressed in terms of a cost function: y= a + bx
c. Must be analyzed and segregated into its variable and fixed component

As to Controllability:
Controllable versus Uncontrollable depending on the decision maker (responsible entity)
- Those that has the capacity to decide that incurrence of costs.

1. Controllable - cost that can be influenced by a decision. (avoidable/discretionary/optional)

2. Non-controllable - cost that are influenced by another party's decisions.

As to Role in Decision Making/Relevance:

1. Differential Costs - costs that differs between two alternatives

2. Opportunity Costs - benefits that are forgone by choosing another alternative.
3. Sunk Costs - costs that are already incurred and paid for and cannot be returned

As to Quality:
Costs associated with non-achievement of product/service quality.

1. Costs of achieving Good Quality (conformance)

a. Preventive Costs - costs incurred before any defect has occurred.
b. Appraisal Costs- costs of measuring, testing, and analyzing whether a defect has occurred.

2. Costs of Poor Quality (non-conformance)

a. Internal failure costs - defects detected inside the company's premises include scrap, rework process failure, downtime, and
price reductions
b. External failure costs - defects were detected outside or by a customer include complaints returns, warranty claims, liability,
and lost sales

Phases in Analyzing Mixed Costs:

Cost Behavior Cost Estimation Cost Prediction

  Cost Behavior - identifying whether a particular costs is variable, fixed or mixed
 Cost Estimation - determining the variable (per unit cost) and fixed (total) components,
 Cost Prediction - forecasting the costs to be incurred connection with the expected activity level

Methods of Analyzing Mixed Costs:

1. Qualitative Approach - uses human judgment

 Account Analysis (what the costs has been?)-based on the analyst's (usually the controller) prior knowledge of how costs
behave.
 Engineering Approach (what costs should be?)- based on an industrial engineers' evaluation of different activities, required
resources (human, equipment, etc.), efficiency, etc.

2. Quantitative Approach - uses quantitative data

 High-Low
 Choosing the highest and lowest activity levels within the relevant range.
y 2− y 1
 Slope of the line: b =
x 2−x 1

 Y-intercept: a = Y - bx

 Scattergraph or Visual Fit

o Drawing a line over a set of plotted data points
o Determine the fixed cost y intercept) by drawing a line over a plotted dates

 Least Square Regression Analysis - an averaging method that is an expansion of the expression y = a+ bx

o Formula : b= n¿¿ a=∑ y−b ¿ ¿ ¿

o Slope or gradient of a line is a number that describes both the direction and the steepness of the line (represented by the
variable cost per unit)

o Y Intercept - the point at which the line crosses the y axis (represented by the total fixed costs since total cost (y) will always
start at fixed costs even if there is no activity (x)

o Coefficient of Correlation (r) - is the measure of the relationship between two sets of data. Its value always lies between -1
to +1

 Positive Correlation - when values of one variable increases with that of another is increased
 Negative correlation - when the values of one variable decreased with that of another are increased or vice versa
 No Correlation - there is no impact on one variable with an increase or decreased of values of another variable

o Coefficient of Determination (r-squared) - indicates how well data points fit a statistical model – sometimes simply line or
curve. It is a statistic that will give some information about the goodness of fit of a model.

o Standard Error - is the standard deviation of the sampling distribution of a statistic. The term may also be used to refer to an
estimate of that standard deviation, derived from particular sample used to compute the estimate.

Reports pertaining to costs information:

AAV Company AAV Company
Cost of Goods Manufactured Cost of Goods Sold
For the year ended ______ For the Year Ended _____
Beginning – DM P xx Beginning - FG P xx
Add: Purchases ____Xx Cost of Goods Manufactured ____Xx
Total Available for Use Xx Total Goods Available for Sale Xx
Less: Ending - DM ____Xx Less: Ending - FG ____Xx
DM Used Xx Cost of Goods Sold/Cost of Sales Xx
DL Xx
Xx
MO
____Xx
Total Manufacturing Costs
Xx
Add: Beginning - WIP ____Xx
Total Good Put in Process Xx
Less: Ending - WIP ____Xx
Cost of Goods Manufactured xx

Financial Statements for a Manufacturing Business

Balance Sheet for a Manufacturing Business

A manufacturing business reports three types of inventory on its balance sheet as follows:
 1. Materials inventory (sometimes called raw materials inventory). This inventory consists of the costs of the direct and
indirect materials that have not entered the manufacturing process.

Examples for Legend Guitars: Wood, guitar strings, glue, sandpaper

2. Work in process inventory. This inventory consists of the direct materials, direct labor, and factory overhead costs for
products that have entered the manufacturing process, but are not yet completed (in process).

Example for Legend Guitars: Unfinished (partially assembled) guitars

3. Finished goods inventory. This inventory consists of completed (or finished) products that have not been sold.

Example for Legend Guitars: Unsold guitars

Exhibit 1 illustrates the reporting of inventory on the balance sheet for a merchandising and a manufacturing business. Music Land
Stores, Inc., a retailer of musical instruments, reports only Merchandise Inventory. In contrast, Legend Guitars, a manufacturer of
guitars, reports Finished Goods, Work in Process, and Materials inventories. In both balance sheets, inventory is reported in the
Current Assets section.

EXHIBIT 1

Income Statement for a

Manufacturing Company
The income statements for
merchandising and manufacturing businesses differ primarily in the reporting of the cost of merchandise (goods) available for sale and
sold during the period. These differences are shown below.

A merchandising business purchases merchandise ready for resale to customers. The total cost of the merchandise available for sale
during the period is determined by adding the beginning merchandise inventory to the net purchases. The cost of merchandise sold is
determined by subtracting the ending merchandise inventory from the cost of merchandise available for sale.

A manufacturer makes the products it sells, using direct materials, direct labor, and factory overhead. The total cost of making
products that are available for sale during the period is called the cost of goods manufactured. The cost of finished goods available
for sale is determined by adding the beginning finished goods inventory to the cost of goods manufactured during the period. The cost
of goods sold is determined by subtracting the ending finished goods inventory from the cost of finished goods available for sale. Cost
of goods manufactured is required to determine the cost of goods sold, and thus to prepare the income statement. The cost of goods
manufactured is often determined by preparing a statement of cost of goods manufactured. This statement summarizes the cost of
goods manufactured during the period as shown below.
To illustrate,
the following data for Legend Guitars are used:

The statement of cost of goods manufactured is prepared using the following three steps:
Step 1. Determine the cost of materials used.
Step 2. Determine the total manufacturing costs incurred
Step 3. Determine the cost of goods manufactured.

Using the preceding data for Legend Guitars, the preparation of the statement of cost of goods manufactured is illustrated below.

Step 1. The cost of materials used in production is determined as follows:

The January 1, 2010 (beginning), materials inventory of $65,000 is added to the cost of materials purchased of $100,000 to yield the
total cost of materials that are available for use during 2010 of $165,000. Deducting the December 31, 2010 (ending), materials
inventory of $35,000 yields the cost of direct materials used in production of $130,000.

Step 2. The total manufacturing costs incurred is determined as follows:

The total manufacturing costs incurred in 2010 of

$284,000 are determined by adding the direct materials used in production (Step 1), the direct labor cost, and the factory overhead
costs.

Step 3. The cost of goods manufactured is determined as follows:

The cost of goods manufactured of $290,000 is determined by adding the total manufacturing costs incurred (Step 2) to the January 1,
2010 (beginning), work in process inventory of $30,000. This yields total manufacturing costs of $314,000. The December 31, 2010
(ending), work in process of $24,000 is then deducted to determine the cost of goods manufactured of $290,000.

Uses of Managerial Accounting

As mentioned earlier, managerial accounting provides information and reports for managers to use in operating a business. Some
examples of how managerial accounting could be used by Legend Guitars include the following:

1. The cost of manufacturing each guitar could be used to determine its selling price.
2. Comparing the costs of guitars over time can be used to monitor and control the cost of direct materials, direct labor, and factory
overhead.
3. Performance reports could be used to identify any large amounts of scrap or employee downtime. For example, large amounts of
unusable wood (scrap) after the cutting process should be investigated to determine the underlying cause. Such scrap may be caused
by saws that have not been properly maintained.
4. A report could analyze the potential efficiencies and dollar savings of purchasing a new computerized saw to speed up the
production process.
5. A report could analyze how many guitars need to be sold to cover operating costs and expenses. Such information could be used to
set monthly selling targets and bonuses for sales personnel.

Practice Exercise:
Gauntlet Company has the following information for January:
Cost of direct materials used in production P 25,000
Direct labor 35,000 Factory overhead 20,000
Work in process inventory, January 1 30,000
Work in process inventory, January 31 25,000
Finished goods inventory, January 1 15,000
Finished goods inventory, January 31 12,000

For January, determine (a) the cost of goods manufactured and (b) the cost of goods sold.

Answers:

a.
Work in process inventory, January 1 . . . . . . . . . . . . . P 30,000
Cost of direct materials used in production . . . . . P 25,000
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ….35,000
Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 20,000
Total manufacturing costs incurred during January . . . 80,000
Total manufacturing costs . . . . . . . . . . . . . . . . . . . . . . . P 110,000
Less work in process inventory, January 31 . . . . . . . . . 25,000
Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . P 85,000
b.
Finished goods inventory, January 1 . . . . . . . . . . . . . . P 15,000
Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . 85,000
Cost of finished goods available for sale . . . . . . . . . . . P 100,000
Less finished goods inventory, January 31 . . . . . . . . . . 12,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 88,000

ESSAY PROBLEM

The following is a list of costs that were incurred in producing this textbook:
a. Insurance on the factory building and equipment
b. Salary of the vice president of finance
c. Hourly wages of printing press operators during production
d. Straight-line depreciation on the printing presses used to manufacture the text
e. Electricity used to run the presses during the printing of the text
f. Sales commissions paid to textbook representatives for each text sold
g. Paper on which the text is printed
h. Book covers used to bind the pages
i. Straight-line depreciation on an office building
j. Salaries of staff used to develop artwork for the text
k. Glue used to bind pages to cover

Instructions

With respect to the manufacture and sale of this text, classify each cost as either a product cost or a period cost. Indicate whether each
product cost is a direct materials cost, a direct labor cost, or a factory overhead cost. Indicate whether each period cost is a selling
expense or an administrative expense.

Self-Examination Questions
1. Which of the following best describes the difference between financial and managerial accounting?
A. Managerial accounting provides information to support decisions, while financial accounting does not.
B. Managerial accounting is not restricted to generally accepted accounting principles, while financial accounting is restricted to
GAAP.
C. Managerial accounting does not result in financial reports, while financial accounting does result in financial reports.
D. Managerial accounting is concerned solely with the future and does not record events from the past, while financial accounting
records only events from past transactions.

2. Which of the following is not one of the five basic phases of the management process?
A. Planning
B. Controlling
C. Decision making
D. Operating

3. Which of the following is not considered a cost of manufacturing a product?

A. Direct materials cost
B. Factory overhead cost
C. Sales salaries
D. Direct labor cost

4. Which of the following costs would be included as part of the factory overhead costs of a microcomputer manufacturer?
A. The cost of memory chips
B. Depreciation of testing equipment
C. Wages of microcomputer assemblers
D. The cost of disk drives

5. For the month of May, Latter Company has beginning finished goods inventory of P 50,000, ending finished goods inventory of P
35,000, and cost of goods manufactured of P 125,000. What is the cost of goods sold for May?
A. P 90,000
B. P 110,000
C. P 140,000
D. P 170,000