STRATCO REVIEWER

Understanding and Classifying Costs

Costs Control: The Focus of Management Accounting in its Pioneering Years Accountant's perspective

Traditional management accounting deals with the accounting for normal Capital expenditures v. Operating expenditures
operating activities. It relates to the processes of production, sales and
Capital expenditures are outlays normally requiring' large amount of
profitability.
money and resources having a long-term impact to business profitability
The ultimate objective of the operations is to generate the best profit but are initially relating to the investing activities of the organization.
performance out of the resources used. Mathematically, profit increases when These expenditures create probable future economic value and benefit
sales increase and expenses decrease, or both, as shown below: are called as assets when capitalized. These costs are converted to
expense once their related income is generated.
Table 3.1. The Focus of Management Accounting
Examples are those used in long-term projects and long-term
To increase Profit
assets.
Sales P xx ↑
Operating expenditures are outlays or consumption used to directly
Less: Expenses xx ↓ support the normal operating activities of the business. They are
expensed in the period because of the following:
Profit(loss) P xx ↑
Immediate recognition such advertising, salaries, and research,
NOTE: Traditional management accounting is
associating cause and effect such as cost of sales; and, Rational
operations accounting
and systematic allocation such as depreciation reasons:
Traditional management accounting provides intelligent information to managers
Cost v. Expenses v. Loss
in order to reduce expenses and increased profit. Reducing expenses requires
thoroughly understanding it first to be controlled and managed. Costs of goods manufactured are those incurred in producing goods and
resources. Examples are direct materials, direct labor and factory overhead. Costs
To manage cost means to control or reduce it or to justify its priority of
of goods sold are those production costs relating to the units sold.
incurrence. The use of the term "costs" here includes costs and expenses.
Expenses are those incurred in distributing goods and managing a business.
Costs concepts
Marketing promotions and shipping expenditures are distribution expense. Those
Costs In the perspectives of accountants, managers, and economists, costs may relating to systems and control, government compliance and other corporate
be classified as follows: costs incurred to manage the business are referred to as administration expenses.
Both costs and expenses give benefits to the business. Distribution and
Note: To control costs means to understand
administration expenses provide benefits to the business.
them
Losses do not give any benefit to the business. Examples of losses are: loss on
sales of equipment, loss on inventory obsolescence, loss on shortages, spoilage,
and loss on uncollectible.
Product cost v. Period cost
Product costs are those incurred to produce the product. They are inventoriable
and deferred as assets while the related units are unsold. Once sold, the cost of
inventory is transferred from the asset classification to cost of goods sold
classification as an expense. Direct materials, direct labor, and plant overhead are
product costs.
Direct materials and direct labor are
Direct labor and factory overhead are called conversion costs. Direct materials,
direct labor, and variable factory overhead are called variable production costs.
Period costs are those incurred outside of the production activities. They are
incurred to administer a business, sell and distribute a product, conduct
researches, attend to customer's needs which are not related to the production
function. They are automatically expensed once incurred.
Direct product cost v. Indirect product cost
Direct product costs are those that are directly identified with finished goods or
services or those that are directly attributable in the process of making goods or
services (i.c., converting materials into finished goods). There are only three costs
of production: direct materials, direct labor, and factory overhead. Direct
materials and direct labor are direct product costs. Factory overhead is an indirect
product cost.
Manager's perspective
Relevant cost v. 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).
NOTE: Relevant costs are used in making decisions.
Relevant costs are not only differential costs. They are future costs. Those costs
that are not incurred in the future are irrelevant. Past costs, sunk costs, historical
costs are irrelevant costs in making a decision because they can no longer be
changed. Remember, management deals about the future not the past. The
future could be influenced or directed, while the past cannot.
Direct Segment cost vs. Indirect Segment cause
Direct departmental costs are those that are directly identified with the
department, process, segment, or activity. They may be variable or fixed costs.
NOTE: Direct costs may be direct product costs or
direct segment cost.
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 or direct costs
Avoidable cost v. Unavoidable cost
Avoidable costs are those not incurred once an activity is not performed. They
normally become savings on the part of the business. These savings are
considered an inflow in the economic sense and are referred to as imputed costs.
Unavoidable costs are those that would remain to be incurred regardless of
option a manager chooses. They remain constant, they do not change, and are
irrelevant in short-term decisions. Common examples of unavoidable costs are
rent, depreciation, interest, property taxes and all other committed fixed costs.
Controllable cost v. Uncontrollable cost
Controllable costs are those which incurrence or non-incurrence, can be
influenced or decided upon by a manager. The influence or decision-making
power of a manager depends manager on the scope, nature, and extent of
authority granted to him by the organization.
NOTE: Controllable costs are managed or
influenced by a manager
Below is an example of a traditional organizational chart: Out-of-pocket cost v. Non-cash costs

Fig. 3.1. Sample Organizational Chart and Controllable Costs Out-of-pocket costs (OPCs) are those that are incurred and are paid in cash. OPCs
require payments. All costs that are paid in cash are out-of-pocket costs. Those
Workers 1, 2 and 3 are controlledby
that are not paid in cash are non-cash costs.
managers, highlighted in the
presented structure. They are NOTE: Cash expenses are out-of-pocket.
controlled by the Manager 2, Vice-
President 2, and eventually, the Chief Sunk cost v. Future cost
Executive Officér. Workers 1, 2, and 3 Sunk costs are those that have been incurred in the past and can no longer be
are not controlled by Manager 1, changed. They are constant and not differential. They are historical and irrelevant
Manager 3, and Vice-Presidents 1
in short-term decisions.
and 3.
Future costs are to be incurred in the coming periods. They are relevant and are
Planned cost v. Actual cost
of value in making decisions. They are sometimes called planned costs, budgeted
Planned costs are those that relate to future occurrences and are referred to in costs, or estimated costs.
multifarious Planned costs are names such as projected costs, estimated costs, NOTE: Sunk costs are not manageable.
budgeted costs, applied costs, and standard future costs.
Economist's perspective
Actual costs, or explicit costs, are those expenditures already incurred and
recorded in the accounting books. The difference between the planned cost and Explicit cost v. Implicit cost
actual cost is called a planning gap or planning variance.
Explicit costs are actual costs. They are incurred and recorded in the accounting
NOTE: Planned cost are future costs books. Implicit costs are theoretical costs. They are assumed and are not
recognized in the accounting books. Two good examples of implicit costs are
Budgeted cost v. Standard cost
opportunity costs and imputed costs.
Budgeted costs are those expected to be incurred at the level of activity used in
Opportunity cost v. Imputed cost
preparing the master budgets. Standard costs are those expected to be incurred
at "any level of activity" aside from that being used in the master budget. The The benefits given up in favor of another choice are opportunity costs.
level of activity used in computing the standard cost may be actual or estimated.
Imputed costs are those costs not incurred but are implied in a given decision.
The difference between the budgeted cost and standard cost is called a capacity
NOTE: Opportunity costs are given up, imputed costs are
variance.
avoided
NOTE: Budgets normally "master budget". Standard
costs refer to flexible budgets.
Opportunity costs and imputed costs are not recorded in the financial accounting Costs sensitivity
system because they are not actually incurred, they are only theoretical. But they
The behavior of costs in relation to changes in the level of production and sales
are relevant in making a decision.
are graphically presented below:

Incremental cost v. Marginal cost

Figure 3.2. Graphical representation of costs behavior on varying levels of
Incremental costs represent a total increase in costs. Marginal cost is an increase activity
in cost per unit. Decremental costs are decreases in costs.
NOTE: Cost behavior in relation to different production and sales levels
NOTE: Incremental is per total, marginal is
per unit

Variable cost v. Fixed cost NOTE: Economies of scale relates to volume, it relates to fixed costs

Fixed costs are those that remain constant regardless of the change in the level of
production and sales, but changes on a per unit basis. Variable costs change in
total in direct proportion to changes in the level of production and sales but is
constant on a per unit basis.
Mixed Costs
Committed fixed costs are those which incurrence have been committed
These costs have the characteristics of both the fixed and the variable costs. They
by the business in the past by reason of contract, acquisition, or
are called "mixed costs".
agreement

Discretionary (or engineered) fixed costs are those which incurrence is

assured but the amount may change depending on the discretion or value
judgment of the manager
NOTE: Fixed costs are constant in total, and varies
inversely per unit

Variable costs vary directly in proportion to the change in the level of production
and sales. Hence, total variable costs change.

Fixed costs and variable costs are normally expressed in their constant terms.
Hence, fixed costs are normally expressed in total, and variable costs are
expressed on a per unit basis.

NOTE: Variable costs change in total, and is constant per Mixed costs could either be semi-variable costs, semi-fixed costs, or step costs.
unit Semi-variable costs change in total but not in direct proportion to changes in the
level of production and sales. Semi-fixed costs are constant in a given level of or move up anew. The behavior of total costs is explained below following the
activity but changes, not in a constant way, when a new level of activity is learning curve theory.
reached. Step costs are constant in a given level of activity and changes, also in a
constant way as new level of activity is reached. The graphical presentations of
these mixed costs are shown below: The Learning Curve Theory
NOTE: Different types of costs.

Relevant Range

The behavior of costs is predictable within a relevant range. Relevant range is a

band of activity (or stretch of activities) where the behavior of costs, expenses
and revenues is valid

NOTE: Relevant range short range

Long range analysis and the relevant range

Economists and management practitioners know that costs do not really behave
linearly. In the long run, the behavior of sales and costs is not linear as shown
below.:

NOTE: In the long-run, things

change and behave
nonlinearly

Sales inch up slowly until it

breaks the resistance level
and tremendously moves up
in the succeeding years of
product introduction as
inspired by a well-fueled marketing and promotional activities. Later on, sales
decline as the product reaches the level of its maximum acceptance. Now comes
the importance of technology and innovations to repackage the product and spur
an upswing trend in sales. And the process continues, sales go up, mature, decline
As production doubles, men increase their productivity and Total costs increase
dramatically in the
initial years of
business or product
operations. This is
attributable to
"learning curve
theory" where
people, systems, and
processes perform
inefficiently in the
first years of
business operations during which time people and is translated for 20% savings in
processes gain knowledge and experience.

NOTE: 80-20 Rule

Productivity rate increases as production moves up. In general, productivity rate

improves in the vicinity of 65% - 85% as production volume doubles until such
time the best performance is attained.

The learning curve resembles that of the "law of diminishing returns" and
"product life cycle". Learning curve is also related to Pareto Law (or the 80-20
rule). Applied to total costs behavior, the cumulative total costs decrease by
about 80% whenever production doubles.