Cost Concepts

and
Classifications
Learning Objectives
• To understand the cost classifications used for assigning costs
to cost objects: direct costs and indirect costs.
• To Identify and give examples of each of the three basic
manufacturing cost categories
• To understand the cost classifications used to prepare
financial statements: product costs and period costs.
• To understand cost classifications used to predict cost
behavior: variable costs, fixed costs, and mixed costs
• To understand mixed cost using a scatter graph method and
the high-low method.
• To understand cost classifications used in making decisions:
differential costs, opportunity costs, and sunk costs.
Costs

- sacrifice of resources

Example 1: if you purchased an automobile for a cash payment of P12,000,

the cost to purchase the automobile would be P12,000.

Example 2: What are the costs for an individual to obtain a college education?
A student sacrifices cash to pay for tuition and books, clearly a cost. What
about cash paid for living costs? If the student would have to pay these costs
even if she or he did not attend college, one should not count them as costs
of getting a college education
Cost Classifications
Assigning Costs to Cost Objects
Costs are assigned to cost objects for a variety of purposes including
pricing, preparing profitability studies, and controlling spending. A cost
object is anything for which cost data are desired—including products,
customers, jobs, and organizational subunits. For purposes of assigning
costs to cost objects, costs are classified as either direct or indirect.

direct cost is a cost that can be easily and conveniently traced to a

specified cost object

indirect cost is a cost that cannot be easily and conveniently traced to a

specified cost object
Cost Classifications
Manufacturing Costs
Most manufacturing companies further separate their manufacturing costs
into two direct cost categories, direct materials and direct labor, and one indirect
cost category, manufacturing overhead.

Direct Materials: The materials that go into the final product are called raw
materials . This term is somewhat misleading because it seems to imply
unprocessed natural resources like wood pulp or iron ore. Actually, raw materials
refer to any materials that are used in the final product; and the finished product
of one company can become the raw materials of another company.

Raw materials may include both direct and indirect materials. Direct materials
are those materials that become an integral part of the finished product and
whose costs can be conveniently traced to the finished product.
Cost Classifications
Direct labor consists of labor costs that can be easily
(i.e., physically and conveniently) traced to individual
units of product. Direct labor is sometimes called touch
labor because direct labor workers typically touch the
product while it is being made.

Labor costs that cannot be physically traced to particular

products, or that can be traced only at great cost and
inconvenience, are termed indirect labor . Just like
indirect materials, indirect labor is treated as part of
manufacturing overhead.
Cost Classifications
Manufacturing overhead , the third manufacturing cost category,
includes all manufacturing costs except direct materials and direct
labor. Manufacturing overhead includes items such as indirect
materials; indirect labor; maintenance and repairs on production
equipment; and heat and light, property taxes, depreciation, and
insurance on manufacturing facilities.

A company also incurs costs for heat and light, property taxes,
insurance, depreciation, and so forth, associated with its selling
and administrative functions, but these costs are not included as
part of manufacturing overhead. Only those costs associated with
operating the factory are included in manufacturing overhead.
Cost Classifications
Nonmanufacturing Costs
Nonmanufacturing costs are often divided into two categories: (1) selling costs and (2) 
administrative costs. Selling costs include all costs that are incurred to secure customer orders
and get the finished product to the customer. These costs are sometimes called order-getting
and order-filling costs. Examples of selling costs include advertising, shipping, sales travel, sales
commissions, sales salaries, and costs of finished goods warehouses. Selling costs can be either
direct or indirect costs. For example, the cost of an advertising campaign dedicated to one
specific product is a direct cost of that product, whereas the salary of a marketing manager
who oversees numerous products is an indirect cost with respect to individual products.

Administrative costs include all costs associated with the general management of an
organization rather than with manufacturing or selling. Examples of administrative costs include
executive compensation, general accounting, secretarial, public relations, and similar costs
involved in the overall, general administration of the organization as a whole. Administrative
costs can be either direct or indirect costs. For example, the salary of an accounting manager in
charge of accounts receivable collections in the East region is a direct cost of that region,
Cost Classifications
For Preparing Financial Statements

Product costs include all costs involved in acquiring or making a product. In the case of
manufactured goods, these costs consist of direct materials, direct labor, and manufacturing
overhead. Product costs “attach” to units of product as the goods are purchased or
manufactured, and they remain attached as the goods go into inventory awaiting sale.
Product costs are initially assigned to an inventory account on the balance sheet. When the
goods are sold, the costs are released from inventory as expenses (typically called cost of
goods sold) and matched against sales revenue on the income statement. Because product
costs are initially assigned to inventories, they are also known as inventoriable costs .

Period costs are all the costs that are not product costs. All selling and administrative
expenses are treated as period costs. For example, sales commissions, advertising, executive
salaries, public relations, and the rental costs of administrative offices are all period costs.
Period costs are expensed on the income statement in the period in which they are incurred
using the usual rules of accrual accounting.
Cost Classifications
Prime Cost and Conversion Cost
Two more cost categories are often used in discussions of manufacturing costs— prime
cost and conversion cost. Prime cost is the sum of direct materials cost and direct labor
cost. Conversion cost is the sum of direct labor cost and manufacturing overhead cost.

To improve your understanding of these definitions, consider the following scenario: My

Loves company has reported the following costs and expenses for the most recent month:
Direct materials P69,000
Direct labor P35,000
Manufacturing overhead P14,000
Selling expenses P29,000
Administrative expenses P50,000

Compute for the product costs, period costs, conversion costs, and prime costs
Cost Classifications

For Predicting Cost Behavior

Cost behavior refers to how a cost reacts to changes in the level of

activity. As the activity level rises and falls, a particular cost may rise
and fall as well—or it may remain constant. To help make such
distinctions, costs are often categorized as variable, fixed, or mixed.

The relative proportion of each type of cost in an organization is

known as its cost structure . For example, an organization might
have many fixed costs but few variable or mixed costs. Alternatively,
it might have many variable costs but few fixed or mixed costs.
Cost Classifications

Variable cost varies, in total, in direct proportion to changes in the level of activity.
Common examples of variable costs include cost of goods sold for a merchandising
company, direct materials, and direct labor. For a cost to be variable, it must be
variable with respect to something. That “something” is its activity base. An activity
base is a measure of whatever causes the incurrence of a variable cost. An activity
base is sometimes referred to as a cost driver. Some of the most common activity
bases are direct labor-hours, machine-hours, units produced, and units sold.

The behavior of this variable cost, on both a per unit and a total basis, is shown below:
Number of Guests Cost of Meals per Guest Total Cost of Meals 250
P30 P7,500
500 P30 P15,000
750 P30 P22,500
1,000 P30 P30,000
Cost Classifications
Fixed cost is a cost that remains constant, in total, regardless of changes in the level of
activity. Examples of fixed costs include straight-line depreciation, insurance, property taxes,
rent, supervisory salaries, administrative salaries, and advertising. Unlike variable costs, fixed
costs are not affected by changes in activity. Consequently, as the activity level rises and falls,
total fixed costs remain constant unless influenced by some outside force, such as a landlord
increasing your monthly rental expense.

Because total fixed costs remain constant for large variations in the level of activity, the
average fixed cost per unit becomes progressively smaller as the level of activity increases.

The table below illustrates this aspect of the behavior of fixed costs. Note that as the number
of guests increase, the average fixed cost per guest drops.
Monthly Rental Cost Number of Guests Average Cost per Guest P500 250 P2.00
P500 500 P1.00
P500 750 P0.67
P500 1,000 P0.50
Cost Classifications
Committed Fixed costs and Discretionary Fixed costs

For planning purposes, fixed costs can be viewed as either committed or discretionary.
Committed fixed costs represent organizational investments with a multiyear planning
horizon that can’t be significantly reduced even for short periods of time without making
fundamental changes. Examples include investments in facilities and equipment, as well as
real estate taxes, insurance expenses, and salaries of top management. Even if operations
are interrupted or cut back, committed fixed costs remain largely unchanged in the short
term because the costs of restoring them later are likely to be far greater than any short-run
savings that might be realized.

Discretionary fixed costs (often referred to as managed fixed costs ) usually arise from
annual decisions by management to spend on certain fixed cost items. Examples of
discretionary fixed costs include advertising, research, public relations, management
development programs, and internships for students. Discretionary fixed costs can be cut for
short periods of time with minimal damage to the long-run goals of the organization.
Cost Classifications
Responsibility accounting in a factory requires untangling many different causes
and effects. Variance analysis extricates these different factors to reveal who was
responsible for what.
For example, say that a single factory, in a single month, must deal with the
following surprises:

✓ Raw materials cost an extra 5 percent.

✓ Four employees unexpectedly quit.
✓ A shipment of raw materials doesn’t arrive on time, delaying production.
✓ A machine breaks down, requiring unexpected repairs costing $100,000.
✓ The company can raise prices by 10 percent.

Some of these events increase costs, while others cut costs. And the price increase
should boost profits.
Cost Classifications
Linearity Assumption and the Relevant Range

Management accountants ordinarily assume that costs are strictly linear; that
is, the relation between cost on the one hand and activity on the other can be
represented by a straight line. Nevertheless, even if a cost is not strictly linear,
it can be approximated within a narrow band of activity known as the relevant
range by a straight line.

Relevant range is the range of activity within which the assumption that cost
behavior is strictly linear is reasonably valid. Outside of the relevant range, a
fixed cost may no longer be strictly fixed or a variable cost may not be strictly
variable.

Managers should always keep in mind that assumptions made about cost
behavior may be invalid if activity falls outside of the relevant range.
Cost Classifications
Mixed Costs
- contains both variable and fixed cost elements. Mixed costs
are also known as semi-variable costs.

Example: the company incurs a mixed cost called fees paid to

the country. It includes a license fee of P25,000 per year plus
P3 per rafting party paid to the country’s Department of
Natural Resources. If the company runs 1,000 rafting parties
this year, then the total fees paid to the state would be
$28,000, made up of $25,000 in fixed cost plus $3,000 in
variable cost.
Cost Classifications
Separating Mixed Costs into Variable and Fixed Components
Factories and other companies typically must pay costs that include
variable and fixed components, challenging accountants to figure out
which camp these costs belong in. These mixed costs typically change
with the level of activity, but not proportionately.

Therefore, in order to predict cost behavior, you need to split mixed

costs into variable and fixed components with one of four techniques:
✓ Analyzing accounts
✓ Scatter graphing
✓ Using the high-low method
✓ Fitting a regression
Cost Classifications
Analyzing accounts
- an account is classified as either variable or fixed based on the analyst’s
prior knowledge of how the cost in the account behaves. For example,
direct materials would be classified as variable and a building lease cost
would be classified as fixed because of the nature of those costs.

Compose of four steps

1. Break out total costs into individual categories or accounts, such as direct
materials, direct labor, and utilities.
2. Use your knowledge of operations and your common sense to classify
each account as variable or fixed.
3. Place variable costs and fixed costs in separate columns and add them up
4. Compute variable cost per unit by dividing total variable costs by the
number of units produced.
Example: Kpop Company produced 1,200 units

Account Total Variable or Fixed

Direct Materials P20,000 Variable
Direct Labor 45,000 Variable
Depreciation 5,000 Fixed
Fixed Utilities 6,000 Fixed
Variable Utilities 5,000 Variable
Supervisor Salaries 25,000 Fixed
Other Variable Overhead 14,000 Variable
Cost Classifications
Scattergraphing
- helps you visualize the relationship between activity level and
total cost.

Three steps for Scatter Graph

1. Set up a table that shows production level and total cost by
time period.
2. Set up a graph with units produced at the bottom axis and
total cost in the left axis.
3. On this graph, plot each point from the table.
Cost Classification

Example: Data for Scatter Graph

Month Production Total Cost
January 800 93,000
February 1,100 114,000
March 1,200 119,000
April 950 103,000
May 1,300 126,000
June 1,250 124,000
July 1,000 107,000
August 1,050 110,000
September 1,000 105,000
October 900 100,000
November 1,050 110,000
December 1,200 119,500
Cost Classification

Using the high-low method

- estimates variable and fixed costs based on the highest and
lowest levels of activity during the period.

Three steps for High-Low Method

1. Based on a table of total costs and activity levels, determine
the high and low activity levels.
2. Use the high and low activity levels to compute the variable
cost per unit.
3. Figure out the total fixed cost.
Cost Classification

Example: Use the data from the scatter graph

Step 1: High activity level: 1,300 with a total cost of

P126,000 Low activity Level: 800 with a total cost of
P93,000

Step 2: Variable cost per unit = (Total cost of highest

activity – Total cost of lowest activity)/(Units produced
of highest activity – Units produced of lowest activity)
Answer: 66 per unit
Cost Classification

Step 3: Use the Y = a + bX

in this equation:
Y = Total Cost Independent variable
a = Total Fixed Cost
b = Variable Cost per unit
X = level of activity Dependent variable

126,000 = fixed cost + (66 x 1,300)

126,000 = fixed cost + 85,800
Fixed Cost = 40,200
Cost Classification

The Least-Squares Regression Method

- uses all of the data to separate a mixed cost into its fixed and variable components. A
regression line of the form Y =a + bX is fitted to the data, where a represents the total fixed
cost and b represents the variable cost per unit of activity.

Steps for Least Squares Regression Method using excel

1. Enter the data into Excel.
Create a table of data in Excel, listing each month’s production activity level and total cost
2. Run a regression analysis in Excel.
Run a regression on the data in Excel by following these steps:
A. Click on “Data.”
B. Click on “Data Analysis” and then “Regression;” then click on “OK.”
C. Under “Input Y Range,” enter the range for the total cost data, including the heading
D. Under “Input X Range,” enter the production data, including the heading.
E. Click on the box for “Labels.”
F. Select an output range on your spreadsheet.
G. Click on “OK.”

When regressing total cost on a cost driver, the total cost data always goes into the “Input Y
Range,” and the cost driver data always goes into the “Input X Range.”
Cost Classification

For Decision Making

Decisions involve choosing between alternatives. In business decisions, each
alternative will have costs and benefits that must be compared to the costs and
benefits of the other available alternatives. A difference in costs between any two
alternatives is known as Differential Cost . A difference in revenues (usually just
sales) between any two alternatives is known as differential revenue . A differential
cost is also known as an incremental cost , although technically an incremental cost
should refer only to an increase in cost from one alternative to another; decreases
in cost should be referred to as decremental costs. Differential cost is a broader
term, encompassing both cost increases (incremental costs) and cost decreases
(decremental costs) between alternatives.

The accountant’s differential cost concept can be compared to the economist’s

marginal cost concept. In speaking of changes in cost and revenue, the economist
uses the terms marginal cost and marginal revenue. The economist’s marginal
concept is basically the same as the accountant’s differential concept applied to a
single unit of output. Differential costs can be either fixed or variable.
Cost Classification

Present costs and revenues are compared to projected costs and

revenues in the following table:
Retailer Sales Differential
Distribution Representatives Costs and (Present)
(Proposed) Revenues
Sales (Variable) P700,000 P800,000 P100,000
Cost of goods sold (Variable) 350,000 400,000 50,000 Advertising
(Fixed) 80,000 45,000 (35,000) Commissions (Variable) 0
40,000 40,000
Warehouse depreciation (Fixed) 50,000 80,000 30,000
Other expenses (Fixed) 60,000 60,000 0
Total expenses 540,000 625,000 85,000
Net operating income P160,000 P175,000 P15,000
Cost Classification
Opportunity Cost and Sunk Cost
Opportunity cost is the potential benefit that is given up when
one alternative is selected over another. Opportunity costs are
not usually found in accounting records, but they are costs that
must be explicitly considered in every decision a manager makes.
Virtually every alternative involves an opportunity cost.

A sunk cost is a cost that has already been incurred and that
cannot be changed by any decision made now or in the future.
Because sunk costs cannot be changed by any decision, they are
not differential costs. And because only differential costs are
relevant in a decision, sunk costs should always be ignored.
 Traditional and Contribution Format Income
Statements
Traditional income statements are prepared primarily for
external reporting purposes. This type of income statement
organizes costs into two categories—cost of goods sold and
selling and administrative expenses. Sales minus cost of goods
sold equals the gross margin. The gross margin minus selling
and administrative expenses equals net operating income.

The cost of goods sold reports the product costs attached to the
merchandise sold during the period. The selling and
administrative expenses report all period costs that have been
expensed as incurred.
 Traditional and Contribution Format
Income Statements
Contribution Format Income Statement
The crucial distinction between fixed and variable costs is at the heart of
the contribution approach to constructing income statements. The unique
thing about the contribution approach is that it provides managers with an
income statement that clearly distinguishes between fixed and variable
costs and therefore aids planning, controlling, and decision making.

The contribution approach separates costs into fixed and variable

categories, first deducting variable expenses from sales to obtain the
contribution margin. For a merchandising company, cost of goods sold is a
variable cost that gets included in the “Variable expenses” portion of the
contribution format income statement. The contribution margin is the
amount remaining from sales revenues after variable expenses have been
deducted. This amount contributes toward covering fixed expenses and
then toward profits for the period.
Traditional and Contribution Format
Income Statements
Comparing Traditional and Contribution Format Income
Statements for Merchandising Companies (all numbers are
given)
Traditional Format
Sales P12,000
Cost of goods sold 6,000
Gross 6,000
Selling and administrative expenses:
Selling P3,100
Administrative 1,900 5,000
Net operating income P1,000
Traditional and Contribution Format
Income Statements
Contribution Format

Sales P12,000 Variable expenses:

Cost of goods sold P6,000
Variable selling 600
Variable administrative 400 7,000
Contribution margin 5,000
Fixed expenses:
Fixed selling 2,500
Fixed administrative 1,500 4,000
Net operating income P 1,000
Exercises

Exercise 1: Martinez Company’s relevant range of production is 7,500 units to

12,500 units. When it produces and sells 10,000 units, its unit costs are as
follows:

Amount Per Unit

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . P6.00
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.50
Variable manufacturing overhead . . . . . . . . . . . . . 1.50
Fixed manufacturing overhead . . . . . . . . . . . . . . . 4.00
Fixed selling expense . . . . . . . . . . . . . . . . . . . . . . 3.00
Fixed administrative expense . . . . . . . . . . . . . . . . 2.00
Sales commissions . . . . . . . . . . . . . . . . . . . . . . . . 1.00
Variable administrative expense . . . . . . . . . . . . . . 0.50
Exercises
Required:
1. For financial accounting purposes, what is the total amount of product costs incurred to make 10,000 units?
2. For financial accounting purposes, what is the total amount of period costs incurred to sell 10,000 units?
3. If 8,000 units are sold, what is the variable cost per unit sold?
4. If 12,500 units are sold, what is the variable cost per unit sold?
5. If 8,000 units are sold, what is the total amount of variable costs related to the units sold?
6. If 12,500 units are sold, what is the total amount of variable costs related to the units sold?
7. If 8,000 units are produced, what is the average fixed manufacturing cost per unit produced?
8. If 12,500 units are produced, what is the average fixed manufacturing cost per unit produced?
9. If 8,000 units are produced, what is the total amount of fixed manufacturing cost incurred to support this
level of production?
10. If 12,500 units are produced, what is the total amount of fixed manufacturing cost incurred to support this
level of production?
11. If 8,000 units are produced, what is the total amount of manufacturing overhead cost incurred to support
this level of production? What is this total amount expressed on a per unit basis?
12. If 12,500 units are produced, what is the total amount of manufacturing overhead cost incurred to support
this level of production? What is this total amount expressed on a per unit basis?
13. If the selling price is $22 per unit, what is the contribution margin per unit sold?
14. If 11,000 units are produced, what are the total amounts of direct and indirect manufacturing costs incurred
to support this level of production?
15. What total incremental cost will Martinez incur if it increases production from 10,000 to 10,001 units?
Exercise 2
The Cheyenne Hotel in Big Sky, Montana, has accumulated records of the total electrical costs of the hotel and the
number of occupancy-days over the last year. An occupancy-day represents a room rented out for one day. The hotel’s
business is highly seasonal, with peaks occurring during the ski season and in the summer.
Month Occupancy-Days Electrical Costs
January 1,736 P4,127
February 1,904 4,207
March 2,356 5,083
April 960 2,857
May 360 1,871
June 744 2,696
July 2,108 4,670
August 2,406 5,148
September 840 2,691
October 124 1,588
November 720 2,454
December 1,364 3,529

Required:
1. Using the high-low method, estimate the fixed cost of electricity per month and the variable cost of electricity per
occupancy-day. Round off the fixed cost to the nearest whole dollar and the variable cost to the nearest whole cent.
2. What other factors other than occupancy-days are likely to affect the variation in electrical costs from month to month?
END