COSTS – CONCEPTS AND

CLASSIFICATION

PROF. ROCINANTE D. CERVANTES, CPA, MBA

Learning Objectives
▪ Distinguish between cost, expenses, and
losses.
▪ Distinguish between direct and indirect
costs.
▪ Define the three integral components of a
product.
▪ Define prime costs and conversion costs.
▪ Define variable, fixed, and mixed costs and
discuss the effects of changes in volume on
these costs.
▪ Distinguish between common costs and
joint costs.
▪ Distinguish between capital expenditures
and revenue expenditures.
▪ Identify the costs for planning, control and
analytical processes.
Costs and it’s definition
Costs are associated with all types of organizations – business, non-
business, service, retail, and manufacturing.

It is incurred to produce future benefits in a profit making firm , future

benefits usually mean revenue. Expired costs are called expenses. While
a loss is a cost that expired without producing any revenue benefit.
Cost Classification – Manufacturing/
Product Cost
Manufacturing/ Product Cost – Direct
Materials
Direct Materials are the basic ingredients that are transformed into
finished products through the use of labor and factory overhead in
the production process.

- Those that can be traced to finished product and form part of the
product.

Indirect Materials – minor materials and other production supplies

that cannot be conveniently or economically traced to specific
products. These are part of factory overhead cost.
Manufacturing/ Product Cost – Direct Labor

Direct Labor include all labor costs for

specific work performed on products that
can be conveniently and economically
traced to end products.

Indirect Labor includes wages and

salaries that cannot be conveniently and
economically traced to end products.
These are part of factory overhead.
e.g wages and salaries of machine
helpers, supervisors, and other support
personnel.
Manufacturing/ Product Cost –
Manufacturing/Factory Overhead

Factory overhead is a catchall for manufacturing costs that

cannot be classified as direct materials or direct labor costs.
Costs that are essential for the production but cannot be
conveniently traced to the end product.
Non-Manufacturing Costs/Period Costs
Prime Cost and Conversion Cost
Cost Classification as to Variability

It involves the way a cost changes in relation to changes in the

activity of an organization.

Activity refers to a measure of the organization’s output of

products or services.

ACTIVITY COSTS
▪ Number of ▪ Total direct
manufactured shoes materials cost

▪ Hours of work ▪ Total direct labor

cost
Cost Classification as to Variability

How a cost will react to

changes in the level of
business activity.
❖ Total variable costs change
when activity changes.
❖ Total fixed costs remain
unchanged when activity
changes.
Fixed Cost

Fixed Cost – Items of cost which remain constant in total, irrespective of

the volume or production.

- Cost per unit decreases as volume increases, and increases as volume

decreases.

e.g. salaries of production executives, depreciation of equipment,

periodic rent payment and insurance.
Fixed Cost

Activity Fixed cost per unit Total Fixed Cost

1 P 1,500 1,500
2 750 1,500
5 300 1,500
10 150 1,500
20 75 1,500
30 50 1,500
Fixed Cost
Fixed Cost

Committed Fixed Costs – costs that represent relatively long term

commitments on the part of management as a result of a past decision.
Example – depreciation on equipment.

Managed fixed costs (also known as discretionary, programmed, or

planned fixed cost) – costs that are incurred on a short-term basis and
can be more easily modified in response to changes in management
objectives.
Examples – advertising, research and development and costs of training
of employees.
Variable Cost

These are the items of cost which vary directly, in total, in relation to
volume of production. Cost per unit remains constant as volume changes
within a relevant range ( e.g. direct materials, direct labor, royalties and
commission of a salesmen).
Variable Cost

Activity Variable cost per Total Variable Cost

unit
1 P 100 100
2 100 200
20 100 2,000
30 100 3,000
Variable Cost vs Fixed Cost
Mixed Cost

Mixed Cost – Items of cost with

fixed and variable components.

a. Semi-variable cost. The fixed

portion of a semi-variable cost
usually represents a minimum fee
for making a particular item or
service available. The variable
portion is the cost charged for
actually using the service.
Mixed Cost

b. Step cost. The fixed part

of step costs changes
abruptly at various activity
levels because these costs
are acquired in indivisible
portions. A step cost is
similar to a fixed cost within
a very small relevant range.
Methods of Separating Mixed Cost

a. Scatter Graph

b. High- Low Point

c. Method of Least Square

Methods of Separating Mixed Cost
a. High – Low Method – analyzes mixed cost by first selecting the
highest and lowest levels of activity in a data set if these two
points are within the relevant range.

Total Cost = Fixed Cost + Variable Cost per unit (Activity Level)
Y =a + b (X)

Y = a+bX
High-low method
Step 1: Select the highest and lowest levels of activity within the relevant
range and obtain the costs associated with those levels.

Step 2: Calculate the change in cost compared to the change in activity.

Step 3: Calculate the change in cost compared to the change in activity to

find the variable cost component.

Step 4: Compute total variable cost (TVC) at either level of activity.

Step 5: Subtract total variable cost from total cost at the associated level
of activity to determined the fixed cost.

Step 6: Substitute the fixed and variable cost values in the straight-line
formula to get an equation that can be used to estimate total cost at any
level of activity within the relevant range.
High-low method
Illustration:
Summary of electricity cost and direct labor hours
Month Direct Labor hrs Cost of Electricity
January 28 625
February 24 565
March 30 630
April 33 640
May 38 685
June 34 640
July 35 655
August 40 700
September 42 715
October 47 726
November 43 700
December 32 630
High-low method
Step 1: Select the highest and lowest levels of activity within the relevant
range and obtain the costs associated with those levels.
Month Direct Labor hrs Cost of Electricity
January 28 625
LOWEST February 24 565
March 30 630
April 33 640
May 38 685
June 34 640
July 35 655
August 40 700
September 42 715
HIGHEST October 47 726
November 43 700
December 32 630
High-low method
Step 2: Calculate the change in cost compared to the change in activity.

Direct Labor hrs Cost

Highest month (Oct.) 47 P 726
Lowest month (Feb.) 24 565
Difference 23 P 161

Step 3: Calculate the change in cost compared to the change in activity to

find the variable cost component.

Variable rate per direct labor hour = P 161

23 hours
= P 7/ direct labor hour
High-low method
Step 4: Compute total variable cost (TVC) at either level of activity.

Step 5: Subtract total variable cost from total cost at the associated level
of activity to determined the fixed cost.
total cost – variable cost per unit (activity level)
High Low
Total cost of electricity P 726 P 565
Less: variable proportion
(P7 X 47) 329
(P7 X 24) 168
Monthly Fixed Cost P 397 P 397
High-low method
Step 6: Substitute the fixed and variable cost values in the straight-line
formula to get an equation that can be used to estimate total cost at any
level of activity within the relevant range.

Y = a+bX
Variable cost

Y = 397 + P7X

Fixed Cost

Wherein Y = Total cost

X = Activity
Exercise
Please answer the following:

Chapter 2 – problems 5 to 9
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SEE YOU ALL NEXT WEEK!