Mindanao State University
College of Business Administration and Accountancy
DEPARTMENT OF ACCOUNTANCY
Marawi City
COST CONCEPTS AND CLASSIFICATIONS
Accounting 142
MEANING OF COST AND ITS USES
One objective of management accounting is to determine the cost of
products, services, customers and any other items of interest to man-
agers. In understanding costs and as to how it can be used by manage-
ment, the following terms and concepts are relevant:
A. Cost – foregoing or potential expenditures (any form of cur-
rent or future cash outlay) measured in monetary terms to
achieve a specific objective; a sacrifice required to attain a
given objective.
B. Expenses – measured outflow of goods and services that are
matched against revenues to determine income; an expired
cost.
C. Loss – a form of expired cost that is not beneficial to revenue
producing activities of the enterprise; no benefits were de-
rived from this particular cost.
D. Cost object – anything for which cost is computed such as a
customer, product, a product line or a segment of an organiza-
tion.
E. Cost driver – any variable such as a level of activity or vol-
ume that usually affects costs over a period of time.
F. Activity – an event, action, transaction, task or unit of work
with a specified purpose. Activities can be classified into:
 Value adding activities – activities that are necessary or
non-eliminable to produce the products such as
assembling the different component parts of the
product.
 Non-value adding activities – activities that do not
make the product or service more valuable to customer
such as moving the materials and equipment parts
from/to stockroom or a workstation.
G. Value chain – a set of activities that a firm operating in a
specific industry performs in order to deliver a valuable
product or service for the organization’s customers.
 Research and development – experimenting to reduce
costs or improve quality.
 Design – developing alternative product, service or
process designs.
 Supply – managing raw materials received from
vendors to reduce costs and improve quality.
 Production – acquiring and assembling resources to
produce a product or render a service.
 Marketing – promoting a product or service to current
and prospective customers.
 Distribution – delivering a product or service to a
customer.
 Customer service – supporting customers after the sale
of a product or service.
H. Cost pool – a grouping of individual cost items; an account in
which a variety of similar costs are accumulated such as work
in process and factory overhead control accounts.
CLASSIFICATIONS OF COSTS
Costs can be classified in a number of ways depending on the purpose
of the classification. Such classifications of costs are not mutually ex-
clusive.
A. Classification as to function:
 Manufacturing costs – production costs of factory re-
lated activities or those that are incurred to transform
materials to finished goods.
a. Direct manufacturing cost – those that are
easily traceable to specific units of production
such as direct labor and direct materials.
b. Indirect manufacturing cost – those collec-
tion of product costs cannot be practically or
conveniently traced to end products such as
factory overhead.
 Non-manufacturing costs – the operating expenses of
the business or those costs not incurred in transforming
materials to finished goods.
a. Marketing expenses – distribution expense or
selling expensesor those that covers the ex-
penses of making sales and delivery of prod-
ucts sold.
b. Administrative expenses – expenses incurred
in the direction, control and administration of
the organization.
c. Research and development – incurred in de-
signing and bringing new products to the mar-
ket.
d. After-sales costs – costs incurred in dealing
with customers after sales such as warranty
and repair costs.
B. Classification as to applicability to accounting periods:
 Capital expenditures – outlays classified first as an as-
set before being recognized as expense.
 Revenue expenditures – outlays classified directly as
an expense.
 Product cost – cost included in the calculation of
inventory costs; also known as inventoriable costs.
 Period cost – costs charged against current period
operations and treated as expense immediately.
C. Classification according to managerial influence:
 Controllable cost – cost that is subject to influence by a
particular manager within the time period under
consideration.
 Non-controllable cost – cost which a manager does not
have a significant influence over.
D. Classification for planning, control and decision making
purposes:
 Standard cost – costs pegged at a predetermined rate
usually expressed on a per unit basis; in total, it is the
cost that “should have been incurred” for actual
production.
 Budgeted cost – future costs usually expressed in totals;
in total, the cost represents the “should be incurred” for
budgeted production.
 Relevant costs – future costs that will differ under
alternative courses of actions.
 Irrelevant cost – costs that will not affect the decision
making process, thus, is ignored in the analysis.
 Differential cost – difference in cost between any two
alternative courses of action.
a. Incremental costs – increase in cost from one
alternative to the other.
b. Decremental costs – decrease in cost from one
alternative to the other.
 Marginal cost – additional costs expressed on a per unit
basis.
 Postponable costs – costs that may be deferred or
shifted to a future date or period of time without
adversely affecting current operations.
 Avoidable cost – cost that can be eliminated in whole or
in part when one alternative is chosen over another in a
decision making case.
 Unavoidable cost – costs that remain regardless of what
decision or alternative is chosen.
 Out of pocket cost – cost that require current or future
cash outlay.
 Opportunity cost – cost of benefits foregone as the
result of the acceptance of an alternative. It is measured
as the benefits that would result from the next best
alternative use of the same resources that were rejected
in favor of the one accepted.
 Imputed cost – hypothetical cost representing the usage
value of a particular resource.
 Sunk or past or historical cost – cost which are already
incurred and therefore irrelevant in decision making
process.
E. Classification in relation to a cost object:
 Direct cost – costs that are related to a particular cost
object and can be economically and effectively be
traced to that cost object.
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  Indirect costs – cost that are related to a cost object but
cannot practically, economically and effectively be
traced to such cost object.
Factors affecting the direct-indirect cost classification
follow:
a. Materiality of the cost in question.
b. Design of operations.
c. Availability of an information-gathering
technology.
d. Choice of cost object.
 Common cost – cost that benefit more than one activity
or department.
 Joint cost – apply to situations where multiple outputs
are derived from one source.
F. Classification as to the tendency to vary with volume or
activity:
 Variable cost – within the relevant range and time
period under consideration, the total amount varies
directly to the change in activity level or cost driver and
the per unit amount is constant.
 Fixed cost – within the relevant range and time period
under consideration, the total amount remains
unchanged and the per unit amount varies inversely or
indirectly with the change in the cost driver.
a. Committed fixed cost – cost that is an in-
evitable consequence of a previous commit-
ment; costs to which management is “stuck”
with over an extended period of time such as
depreciation and long-term lease contract.
b. Programmed or discretionary or managed
costs – cost for which the size or the time of
incurrence is a matter of choice of manage-
ment such as advertising costs and research
and development costs.
 Mixed cost – this cost has both a variable and a fixed
component.
 Step cost – when activity changes, a step cost shifts
upward or downward by a certain interval or step.
a. Step variable cost – a step cost that have
smaller steps.
b. Step fixed cost – a step cost that have larger
steps.
 Non-linear cost – total cost increases but per unit
decreases as activity increases.
To analyze curvilinear costs is to determine the relevant
range represented by the straight-line in the graph.
COST BEHAVIOR ASSUMPTIONS
In management accounting, cost behavior refers to the way in which
costs are affected by fluctuations in the cost driver, i.e. level of activity.
An understanding of cost behavior patterns is essential for many man-
agement tasks, particularly in the areas of planning, decision-making
and control. It would be impossible for managers to forecast and control
costs without at least a basic knowledge of the way in which costs be-
have in relation to the cost driver.
Economists correctly point out that many costs that accountants classify
as variable costs actually behave in a curvilinear fashion. Nonetheless,
within a narrow band of activity, a curvilinear cost can be satisfactorily
approximated by a straight line. In determining cost behavior, certain
assumptions are assumed by the accountant:
A. Relevant range – the band or level of activity where the cost
concepts and the relationship of variable and fixed costs are
considered valid. In the relevant range, the following holds
true:
Total Amount Per Cost Driver
Variable cost Variable Constant
Fixed cost Constant Variable
B. Linearity assumption – within the relevant range, there is a
strict linear relationship between the cost and cost driver. Costs
may therefore be shown as straight lines.
C. Time assumption – the cost behavior patterns identified are
true only over a specified period of time. Beyond this, the cost
may show a different behavior pattern.
Accountants should also be aware that a cost that is considered variable
in one organization may be considered fixed in another due, for exam-
ple, to differing employment policies.
DETERMINING THE COST FUNCTION FOR MIXED COSTS
Mixed costs have variable and fixed cost components, thus:
Total cost (TC) = Fixed cost (FxC) + Variable Cost (VC)
Total variable cost varies directly with the activity level or cost driver,
thus:
Variable cost (VC) = Variable cost per cost driver (b) x Cost driver (x)
Since total cost is linearly related to the activity level or cost driver, the
cost function may be expressed as:
Y = a + bx
where: Y – is the total cost; a – is the total fixed cost; b – variable cost
per cost driver; x – activity level or cost driver.
Needless to say, purely fixed costs may be expressed as Y = a and
purely variable costs as Y = bx.
COST ACCOUNTING AND COST ACCOUNTING SYSTEMS
Cost accounting is that part of the accounting system that measures
costs for decision-making and financial reporting purposes. It involves
the two processes namely:
A. Cost accumulation – involves collection of cost data in some
organized means in an accounting system.
B. Cost assignment – involves tracing and allocating accumu-
lated costs to cost objects.
Examples of cost accounting systems commonly used by businesses in-
clude:
A. Job order costing – this product costing system is used by
firms that provide limited quantities of products or services
unique to a customer’s needs or specifications. Costs are as-
signed or traced to individual products.
Examples: automobile repair shops and tailoring/dressmaking
business.
B. Process costing – this system is used by firms that produce
many units of a single product or nearly identical products for
long periods at a time.
Examples: soft drinks company and toy manufacturers.
C. Hybrid product-costing system – this costing system incor-
porate features from two or more alternative product costing
systems such as job order and process costing.
Examples: clothing and food processing operations.
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 D. Standard costing – this method uses predetermined factors to
compute the standard cost of materials, labor and factory
overhead so that such costs may be assigned to the various in-
ventory accounts and cost of goods sold and can be used with
the other cost accounting systems.
E. Backflush costing – this is a streamlined cost accounting
method that simplifies, speeds up and reduces accounting ef-
fort or procedures in accumulating product costs. Unlike in the
traditional job order and process costing systems, backflush
costing eliminates the detailed tracking of the cost of work in
process.
F. Activity-based costing system – this costing system uses
multiple drivers to predict and allocate costs to products and
services.
FLOW OF COSTS IN A FIRM
Cost flow refers to the manner in which costs move through a firm
specifically in its accounts and how such costs affect the firm’s state-
ment of financial position and income statement.
Merchandising Firm
Purchases P xxx
Freight or transportation in P xxx
Total P xxx
Purchase discounts (xxx)
Purchase returns and allowances (xxx)
Net purchases P xxx

Merchandise inventory, beginning P xxx

Net purchases P xxx
Total goods available for sale P xxx
Merchandise inventory, ending (xxx)
Cost of goods sold P xxx
Sales P xxx
Cost of sales (xxx)
Gross profit P xxx
Operating expenses (xxx)
Operating income P xxx
Other income P xxx
Other expenses (xxx)
Income before tax P xxx
Income tax (xxx)
Net income P xxx
Manufacturing Firm
For a manufacturing firm, the cost of goods sold is computed differently
as the goods purchased are not sold as is but rather transformed first be-
fore being sold to customers.

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Raw materials inventory, beginning P xxx
Net purchases P xxx
Total raw materials available for use P xxx
Raw materials inventory, ending (xxx)
Direct materials used P xxx
Direct labor P xxx
Manufacturing overhead P xxx
Total manufacturing costs P xxx
Work in process, beginning P xxx
Total costs placed into production P xxx
Work in process, ending (xxx)
Total cost of goods manufactured P xxx
Finished goods, beginning P xxx
Total goods available for sale P xxx
Finished goods, ending (xxx)
Cost of goods sold P xxx

ILLUSTRATIVE PROBLEMS

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PROBLEM 1: Classify the following selected costs below as variable Choose one of the preceding terms to characterize each of the amounts
(V) or fixed (F) cost, product (P) or period (E) cost and direct (D) or in- described below. Each term may be used only once.
direct (I) cost in relation to units or product. A. The cost of feeding 300 children in a public school cafeteria is
P450 per day or P1.50 per child per day. What economic term
_____ _____ _____ 1. Wood is used in the manufacture of tables at describes this P1.50 cost?
a cost of P100 per table. B. The cost of including one extra child in a day-care center.
_____ _____ _____ 2. The tables are assembled by workers at a C. The cost of merchandise inventory purchased five years ago.
cost of P40 per table. The goods are now obsolete.
_____ _____ _____ 3. Workers assembling the tables are super- D. The management of a high-rise office building uses 3,000
vised by a factory supervisor who is paid square feet of space in the building for its own administrative
P25,000 per month. functions. This space could be rented for P30,000. What eco-
_____ _____ _____ 4. Electrical costs of P20 per machine hour are nomic term describes this P30,000 of lost rental revenue?
incurred in the factory in the manufacture of E. The cost of building an automated assembly line in a factory
tables. Four machine hours is needed to is P700,000. A manually operated assembly line would cost
manufacture one table. P250,000. What economic term is used to describe the
_____ _____ _____ 5. The depreciation cost of the machines used P450,000 variation between these two amounts?
in the manufacture of the tables is P40,000 a F. Refer to the preceding question and assume that the firm is
year. currently building the assembly line for P700,000. What eco-
_____ _____ _____ 6. The salary of the president of the company nomic term is used to describe the P700,000 construction
is P100,000 a month. cost?
_____ _____ _____ 7. The company spends P250,000 per year to
advertise its products. PROBLEM 6: Following are costs incurred by Deadwood Manufactur-
_____ _____ _____ 8. Salespersons are paid a commission of P300 ing Corporation during the previous month:
for each table sold. Direct materials P 100,000
_____ _____ _____ 9. Rent paid for the factory building is P20,000 Indirect materials (sand papers, lubricants, nails,
a month. rivets, paint and similar items) 5,000
_____ _____ _____ 10. Insurance premiums paid for the general of- Direct labor 50,000
fice is P15,000 a year. Indirect labor (salary of plant supervisor and
similar items) 10,000
PROBLEM 2: Classify the following fixed costs as normally being ei- Factory light, heat, water and electricity 4,000
ther committed (C) or discretionary (D). Advertising and selling costs 6,000
______1. Depreciation of buildings used in manufacturing opera- Sales commissions of agents 5,000
tions. Depreciation on administration building 3,000
______2. Planned expenditures for research and development. Salaries of administrative personnel 20,000
Depreciation on delivery equipment 3,000
______3. Lease or rent of equipment on a long-term basis.
Depreciation of plant equipment 2,000
______4. Payments of pensions to the retirees of the firm. Insurance on administration building 2,500
______5. Budgeted costs for management training and development. Depreciation of plant buildings 15,000
Property taxes on plant buildings 4,000
PROBLEM 3: For items 1 to 9 that follow, draw a graph that best rep- Insurance on plant buildings 2,500
resents the cost behavior pattern described.
1. Straight-line depreciation on machineries and equipment. Requirements:
2. The cost of chartering a private airplane. The cost is P800 per 1. Compute for Deadwood’s total product costs and total period
hour for the first 6 hours of a flight; it then drops to P600 per costs for the current month.
hour. 2. Compute for Deadwood’s total conversion costs for the current
3. The wages of table service personnel in a restaurant. The em - month.
ployees are part-time workers who can be called upon for as lit-
tle as 4 hours at a time. PROBLEM 7: The following selected costs were extracted from the
4. Weekly wages of store clerks who work 40 hours each week. accounting records of Los Angeles Machining:
One clerk is hired for every 125 sales made during the month. A. Direct materials used in production.
5. The cost of tires used in the production of trucks. B. Wages of machine operators.
6. Outbound shipping charges that increase at a decreasing rate as C. Factory utilities.
sales rise because the firm can use more efficient modes of D. Uncollectible accounts expense.
transportation. Gradually, however, at high levels of sales, E. Sales commissions.
freight costs start to increase at an increasing rate, which reflects F. Salary of Los Angeles Machining's president.
more transactions made to customers in far-away locations. G. Factory depreciation.
7. Equipment leasing costs that are computed at P2 per machine H. Wages of plant security guards.
hour worked. The company pays a maximum of P120,000 per I. Machine lubricant used in production.
month. Identify the costs that would be used to calculate (a) cost of goods
8. The monthly cost of a franchise fee for a fast-food restaurant. manufactured (b) manufacturing overhead, (c) total period costs, (d)
The franchisee must pay P20,000 plus 5% of gross dollar sales. total conversion costs, (e) total direct costs of the credit and collections
9. The cost of electricity during peak demand periods, which is department and (f) inventory valuation.
based on the following schedule: up to 20,000 kilowatt hours –
PROBLEM 8: Data about Cisco Company’s production and invento-
P4,000; above 20,000 kilowatt hours – P4,000 + P0.02 per kilo-
ries for the month of June are as follows:
watt hours.
Purchases of direct materials P 143,440
PROBLEM 4: Walnut Corporation operates a small medical lab in Freight in 5,000
Kansas, one that conducts minor medical procedures, including blood Purchase returns and allowances 2,440
tests and x-rays for a number of doctors. The lab consumes various Direct labor 175,000
medical supplies and is staffed by two technicians, both of whom are Actual factory overhead 120,000
paid a monthly salary. In addition, there is an on-site office manager Inventories:
who is also paid by the month. Finished goods, June 1 68,000
Requirements: Finished goods, June 30 56,000
Work in process, June 1 110,000
1. If the lab's patient count increases by, say, 15%, will the lab's to- Work in process, June 30 135,000
tal operating costs increase by 15%? Explain. Raw materials, June 1 52,000
2. Walnut is considering opening an additional lab in a new subur- Raw materials, June 30 44,000
ban medical building. What will likely happen to the lab's level
Cisco Company applies factory overhead to production at 80% of direct
of fixed cost incurrence? Why?
labor cost. Over or underapplied overhead is closed to cost of goods
PROBLEM 5: The following terms are used to describe various eco- sold at year-end. The company’s accounting period is on a calendar year
nomic characteristics of costs: basis.
Opportunity cost Differential cost Requirements:
Sunk cost Out of pocket cost
Marginal cost Average cost

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 1. What was the amount of over or underapplied factory overhead Fixed manufacturing overhead 40.00
for the month of June? Requirements:
2. Prepare in good form a cost of goods sold statement for Cisco
for the month of June. 1. What is the total cost of producing 1,000 axles, 1,500 axles and
2,000 axles respectively?
PROBLEM 9: Mighty Muffler, Inc., operates an automobile service 2. What is the per unit cost when producing 1,000 axles, 1,500 axles
facility. The table below shows the cost incurred during a month when and 2,000 axles respectively?
600 mufflers were replaced.
Number of Muffler Replacements PROBLEM 11: The Morton Company recorded the following transac-
500 600 700 tions for February 2011:
Total costs: Raw Work in Finished
Fixed costs A P 8,400 J Materials Process Goods
Variable costs B 6,000 K Purchases P 100,000
Beginning inventory 18,000 P 8,000 ?
Total C P14,400 L Ending inventory ? 20,000 P 30,000
Cost per muffler replacement: Direct materials used 90,000
Fixed cost D G M Direct labor ?
Variable cost E H N Manufacturing overhead 115,000
Total F I O (inclusive of indirect
materials used of P10,000)
Fill in the missing amounts, labeled A through O, in the table. Transferred to finished goods
PROBLEM 10: Axle and Wheel Manufacturing currently produces ?
Cost of goods sold ?
1,000 axles per month, though its plant has a capacity of 2,000 axles per
month. The following per unit data apply for sales to regular customers: Sales were P560,000, with sales prices determined by adding a 40%
Direct materials P 200.00 markup to the firm's manufacturing cost. The total cost of direct
Direct manufacturing labor 30.00 materials used, direct labor, and manufacturing overhead during the
Variable manufacturing overhead 60.00 month was P285,000. Calculate the missing values in the records above.

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