Cost Concept and Classification of cost

2.1 Cost Concept

Cost is an amount that has to be paid or given up in order to get something. In business, cost is
usually a monetary valuation of (1) effort, (2) material, (3) resources, (4) time and utilities
consumed, (5) risks incurred, and (6) opportunity forgone in production and delivery of a good
or service.
2.2 Classification of Cost
2.2.1 Direct Costs and Indirect Costs
2.2.2 Classification depends on cost objects (By
( Degree of Traceability of the Product):: -

A. Direct costs – Costs that can be identified specifically with or traced to a given cost object in
an economically feasible way. Example leather in shoe factory

B.Indirect cost – Costs that cannot be identified specifically with or traced to a given cost object
in an economically feasible way. Example rent of building, salaries of manager in shoe firm.

2.2.2 Fixed Costs, Variable Costs

Classification depends on Volume (change in activities)
A. Fixed cost - remains unchanged irrespective of volume of production like factory rent, insurance,
administrative salary etc. The cost per unit fluctuates according to the production. The cost per unit
decreases if production increases and cost per unit increases if the production decreases. That is, the
cost per unit is inversely proportional to the production. For example, if the factory rent is Br. 25,000
per month and the number of units produced in that month is 25,000, then the cost of rent per unit
will be Br. 1 per unit. In case the production increases to 50,000 units, then the cost of rent per unit
will be Br. 0.50 per unit. What will be the cost of rent per unit, if the volume of output decreases
from 25000 to 20000?
B.Variable cost - Variable cost directly associates with unit. It increases or decreases according to
the volume of production. Direct material and direct labor are the most common examples of variable
cost. It means the variable cost per unit remains constant irrespective of production of units.
Example wages of laborers, Cost of direct material
2.2.3 Manufacturing and Non Manufacturing Costs

 Manufacturing costs: These costs are incurred to make a product.

 Manufacturing costs may be simply defined as materials used, direct labor incurred,
and manufacturing overhead incurred. These are the costs that are found on the cost
of goods manufactured statement.

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  Types of manufacturing inventories

Direct materials-resources in stock and available for use to make produce. is material that
becomes part of the finished product and, therefore, significantly adds to the weight or size of the
product. If the final product, for example, is a wooden chair, then the wood used to make the
legs, seat, and back is a direct use of material.

Materials such as glue and screws, usually not significant in amount, are often regarded as an
indirect use. Also material used but not becoming a part of the final product and used for
manufacturing objects such as saw horses or shelves to store paint or other incidental materials
would be regarded as an indirect use of material.

Work-in-Process (or progress)-products started but not yet completed.

Finished Goods-products completed and ready for sale.

Direct factory labor is the cost of labor incurred while work is done on the product itself.
Normally, in one way or another, direct labor affects the physical appearance of the product.
Some factory workers do not actually work on the product itself but provide services necessary
to the over-all manufacturing process. Janitorial services, repair, maintenance service,
supervision of direct workers, and computer support are examples of labor incurred that would
be regarded as indirect factory labor.

The significance of classifying material and labor as an indirect cost is this: indirect material
and indirect factory labor are recorded as manufacturing overhead and, therefore,
becomes a part of the cost of the final product through the use of overhead rates.

 Non manufacturing costs (technically, expenses) are those expenses commonly called
selling and administrative. These are the expenditures incurred in the current period directly
for the benefit of generating revenue. Non manufacturing expenses should not be included in
the cost of inventory.

2.2.4 Product versus Period Costs

Classification depends on financial report

Product costs are costs that are a necessary and integral part of producing the finished product.
Companies record product costs, when incurred, as inventory.

Period costs are nonmanufacturing costs. Period costs include selling and administrative
expenses. In order to determine net income, companies deduct these costs from revenues/ sales in
the period in which they are incurred

2.2.5 Prime Costs and Conversion Costs:

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Direct materials, direct labor, and factory overhead costs are often grouped together for analysis
and reporting purposes.

Prime costs consist of direct materials and direct labor costs.

Conversion costs consist of direct labor and factory overhead costs. Conversion costs are the
costs of converting the materials into a finished product, direct labor is both a prime cost and a
conversion cost

Cost Flows

The cost of Goods Manufactured and the cost of Goods Sold section of the income Statement are
accounting representations of the actual flow of costs through a production system.

Cost of Goods Manufactured

The cost of goods manufactured schedule is used to calculate the cost of producing products for a
period of time.

Formula for cost of goods manufactured (COGM)

Beginning FG inventory XXX

Beginning work in process XX

Direct Material used= BDM+DMP-EDM XX

Direct Manufacturing Labor XX

Manufacturing Overhead XX

Total Work in Process Inventory=BWIP+DMU+MOH+DML XX

Less: Ending Work in Process XX

Total Cost of goods manufactured =TWIP-EWIP XX

Cost of Goods Available For Sale=BFG+CGM XXX

Less: Ending Finished Goods Inventory XX

Cost of Goods Sold =CGAFS-EFG XXX

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 Statement of Profit and Loss
Revenue XXX
Less: Cost of Goods XX

Beginning FG inventory XXX

Beginning work in process XX

Direct Material used= BDM+DMP-EDM XX

Direct Manufacturing Labor XX

Manufacturing Overhead XX

Total Work in Process Inventory=BWIP+DMU+MOH+DML XX

Less: Ending Work in Process XX

Total Cost of goods manufactured =TWIP-EWIP XX

Cost of Goods Available For Sale=BFG+CGM XXX

Less: Ending Finished Goods Inventory XX

Cost of Goods Sold =CGAFS-EFG XXX

Gross profit=Revenue-CGS XXX

Less: Operating Cost

Research & Development Cots XX

Marketing Costs XX

Distribution Costs XX

Customer Service Cost XX

Administrative Cost XX XX

Operating income XXX

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Exercise

Illustration-1: XYZ Textile Factory Purchased DM of Br 440,000 and incurred DL of Br 320,000 during
the year ended June 30, 2015.total factory overheads for the year was Br 280,000.

 The inventory balances are as follows:

Inventories July 1, 2014 June 30, 2015

Materials Br100, 000 Br105, 000
Work in process 121,000 110,000
Finished goods 90,000 105,000
Required: determine
1. DMU
2. CGM
3. CGS

Solution: 1 Formula for cost of goods manufactured (COGM)

Beginning FG inventory 90,000

Beginning work in process 121,000

Direct Material used= BDM+DMP-EDM Br435, 000

Direct Manufacturing Labor 320,000

Manufacturing Overhead 280,000.

Total Work in Process Inventory=BWIP+DMU+MOH+DML Br1, 156, 000

Less: Ending Work in Process 110,000

Total Cost of goods manufactured =TWIP-EWIP 1,046,000

Cost of Goods Available for Sale=BFG+CGM 1,136,000

Less: Ending Finished Goods Inventory 105,000

Cost of Goods Sold =CGAFS-EFG 1, 031,000

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 Illustration-2: Assume the ff information about the year 2009 to see how costs flow in the
manufacturing firm.
 Revenue Br 210,000
 Direct material purchased Br 73,000
 Period costs Br 70,000
 Direct manufacturing labor cost Br 9000
 Manufacturing Overheads Br 20000

 Inventories Jan 1, 2009 December 31, 2009

 Materials Br11, 000 Br8, 000
 Work in process 6,000 7,000
 Finished goods 22,000 18,000
1. DMU
2. CGM
3. CGS
4. Prepare statement of cost of goods manufacture and Statement of Profit and Loss

Solution: 2 Formula for cost of goods manufactured (COGM)

Beginning FG inventory 22,000

Beginning work in process 6,000

Direct Material used= BDM+DMP-EDM Br76, 000

Direct Manufacturing Labor 9,000

Manufacturing Overhead 20,000.

Total Work in Process Inventory=BWIP+DMU+MOH+DML Br111, 000

Less: Ending Work in Process 7,000

Total Cost of goods manufactured =TWIP-EWIP 104,000

Cost of Goods Available for Sale=BFG+CGM 126,000

Less: Ending Finished Goods Inventory 18,000

Cost of Goods Sold =CGAFS-EFG 108,000

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 XYZ manufacturing firm
Statement of Profit and Loss
For the Year ended December 31, 2009
Revenue Br 210,000
Less: Cost of Goods Sold Br 108,000
Gross profit Br 102,000

Less:- Operating Cost Br 70,000

Operating income Br 32,000

Illustration-3: The flow of manufacturing costs to the income statement for Legend Guitars, assume the
following data for 2011: Prepare statement of cost of goods manufacture and income statement.

Inventories January 1 December 31

Materials Br 65,000 Br 35,000
Work in process 30,000 24,000
Finished goods 60,000 62,500
Materials purchased during the year………………. Br 100,000
Direct labor incurred in production………………… 110,000
Factory overhead incurred in production:
Indirect labor……………………….…………………. Br 24,000
Depreciation on factory equipment…………………… 10,000
Factory supplies and utility costs ………………………10,000
Total FOH ……………………………………….……...44,000
Selling expenses …………………………………………20,000
Administrative expenses ……………………………….15, 000
Sales…………………………………………………….. 366,000
Solution: 3 Formula for cost of goods manufactured (COGM)

Beginning FG inventory 60,000

Beginning work in process 30,000

Direct Material used= BDM+DMP-EDM Br130, 000

Direct Manufacturing Labor Br 110,000

Manufacturing Overhead 44,000

Total Work in Process Inventory=BWIP+DMU+MOH+DML Br314, 000

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 Less: Ending Work in Process 24,000

Total Cost of goods manufactured =TWIP-EWIP 290,000

Cost of Goods Available for Sale=BFG+CGM 350,000

Less: Ending Finished Goods Inventory 62,500

Cost of Goods Sold =CGAFS-EFG 287,500

Legend Guitars manufacturing firm

Statement of Profit and Loss
For the Year ended December 31, 2011
Revenue Br 366,000
Less: Cost of Goods Sold Br 287,500
Gross profit Br 78,500

Less: Operating Cost Br 35,000

Operating income Br 43,500