CHAPTER TWO

COST TERMS AND CLASSIFICATIONS

1.1 Introduction

1.2 Definition and Classification of Costs

Definition of Costs
The word ‘cost’ is usually used in our day to day conversation. It is a generic term that anyone needs
to know. Cost is the amount of resource given up in exchange for some present and future benefits.
The resource given up is always expressed in terms of money. Cost plays a significant role in
managerial functions such as planning, controlling, decision-making, and directing operation
activities. To guide decisions, managers want to know the cost of something. This ‘something’ may be
a product, a service, a department, or any activity. We call this ‘something’ cost object and is defined
as anything for which a separate measurement of cost is desired. Always activities consume resources
and resources involve costs.
1.2.1 Classification of costs
Different cost concepts and classifications are used for different purposes. Understanding these
concepts and classifications enables the cost accountant to provide appropriate costs data to the
managers who need it. The purpose of the classification determines how the classification should be
done. Cost data classified and recorded in a particular way for one purpose could be inappropriate for
another use.
For example, classification of costs for purposes of determining inventory valuations and cost of
goods sold for external reports differs from the classification of costs that would be carried out to aid
decision-making.

It is important to note that the classifications of costs are not mutually exclusive. That is, a particular
cost may be classified in many different ways—depending upon the purpose of the classification.
Cost accountants classify costs to meet the particular information need at hand. In practice, the
following classifications are used extensively. More than one may be used in any given circumstance.
You may encounter other classifications in practice.
Cost classifications are needed for the development of cost data that will help (aid) management in
achieving its objectives.
These classifications are based on the following:
1. Relationship of the cost to the product.
2. The department where the cost is incurred.
3. The major Functional areas.
4. Relationship of the cost to the production process.
5. The period to which the cost is charged to income.
6. Relationship of the cost to volume of production.
7. The ability to be traced
8. Relationship of cost to planning, controlling, and decision making.
1. Relationship of the cost to the product
Based on the relation ship of costs to the product, costs can be classified as direct material, direct
labor, and overhead costs. This classification provides management with information necessary for
income measurement and product pricing. The elements of a product cost are: - Materials, Labor and
Others facilities (called factory overhead costs)

Page 1 of 15
I. MATERIALS: - are the principal substances used in production that are transformed into finished
goods by the addition of direct labor and factory overhead. The cost of materials may be divided into
direct and indirect.
Direct materials cost: -These are cost of all materials used in the production process that can be
identified with the finished product, that can be easily and economically traced to the product and that
represent a major material cost of producing that product. They are the integral part of finished
products.
Indirect materials costs: - These are all materials used in the production of a product, that can not be
easily and conveniently traced to the product, and that do not represent significant material cost of the
product. It is difficult to determine such costs on a per unit basis as a result these will be considered as
part of the factory overhead.
II. LABOR: - is the physical and/or mental effort expended in the production of a product. Labor
costs are divided into direct and indirect.
Direct labor cost: - It represents the cost of all labor actually involved in the production of a product,
that can be easily and economically traced to the product in an economically feasible way and that
represent a major labor cost of producing that product.” Economically feasible” means “cost effective
“, in the sense that managers do not want cost accounting to be too expensive in relation to expected
benefits. It is the wage cost of employees working directly on the product as assemblers, machinists,
painters, welders, and some machine operators. Direct labor is sometimes referred to as "touch labor"
since it consists of the costs of workers who "touch" the product as it is being made. Direct labor is
declining as a percentage of total manufacturing cost as automation increases in manufacturing
facilities.
Indirect labor cost: -It is cost of labor expended in the production process indirectly and that can not
be easily traced to the product and is part of the manufacturing overhead. Indirect labor include factory
line supervisors, factory department heads, factory clerical workers, time keepers, janitors and factory,
guards, receiving clerks (material handlers), maintenance persons, fringe benefits to both direct and
indirect laborers
III. FACTORY OVERHEAD (FOH)
It consists of all manufacturing costs other than direct materials and direct labor. It is an all-inclusive
cost pool used to accumulate all indirect manufacturing costs, which cannot be directly identified with
specific cost object. These costs cannot be easily and conveniently traced to products. All indirect
material and labor and many other costs including depreciation on manufacturing facilities are
synonymous with indirect manufacturing cost. Overhead benefits some or all manufacturing activities
but cannot be related to individual products. FOH is sometimes called manufacturing overhead,
factory burden, and indirect manufacturing expenses.
Examples of FOH include indirect materials cost, indirect labor cost, factory rent, factory insurance,
heat, light and power, factory depreciation etc.
Therefore, the following equations hold true
FOH costs = Indirect Material + Indirect Labor + Other Indirect Manufacturing Costs
Manufacturing Cost = Direct Material Cost + Direct Labor Cost + FOH
Here is a partial listing of the most common costs in a typical factory operation.

Indirect materials Indirect labor Other manufacturing overheads

- Shop supplies - Factory line supervisors - Employee fringe benefits
- Lubricants - Factory clerical workers - Payroll taxes
- Factory office supplies - Timekeepers - Workers’ compensation insurance
- Small tools - Factory superintendents - Factory utilities
- Packaging materials - Janitors - Rent of factory building, warehouse,
-Items used in small - Receiving clerks and equipment
amounts in the - Storeroom supervisors/clerks -Depreciation of factory building
Page 2 of 15
manufacturing process - Purchasing employees &equipment
-Idle-time costs of direct - Fire and casualty insurance
workers - Property taxes
- Overtime premiums of direct - Group insurance for factory employees
workers - Repairs and maintenance
- Spoiled goods

2. The department where the cost is incurred

In manufacturing businesses departments can be classified into manufacturing (or producing) and non-
manufacturing (or service) departments. The manufacturing/non-manufacturing cost classification is
important in all cost accounting functions.
Producing department costs: are costs incurred in departments that contribute directly to the
production of the item and include costs of departments in which conversion and production process
takes place.
Service department costs: are costs incurred in departments which are not directly related to the
production of the item but provide services to other departments. The cost of maintenance, accounting,
health and other departments are considered as non-manufacturing or service department costs.
3. Major Functional areas
Costs can also be classified based on the functional areas of an organization. All costs of a
manufacturing organization may be divided into manufacturing, marketing, administrative and
financing.
Manufacturing costs: are costs related to the manufacturing or production process of an item. It is the
sum of direct material, direct labor, and factory overhead.

Marketing costs: are costs incurred in promoting or selling a product or service. Examples include
advertisement costs, transportation costs, etc.

Administrative costs: are incurred in directing, controlling and operating a company. The salary of the
general manager is an example.

Financing cost: are costs related to obtaining funds to operate the company. Example is interest
expense.
4. Relationship of the cost to the production process
Based on the relationship of the costs to the production process, we can classify costs into prime costs
and conversion costs.
Prime costs are costs which are directly related to the production of a product. Prime cost is the sum
of direct material costs and direct labor costs.
Conversion costs, called processing costs, are costs concerned with transforming direct materials into
finished products. They are the sum of direct labor and factory overhead costs. Therefore, the
following equations hold true:

Prime cost = DM + DL
Conversion Cost = DL + FOH
Manufacturing Cost = Direct Material Cost + Direct Labor Cost + FOH
Manufacturing Cost = PC + CC – DL
5. The period to which the cost is charged to income
Costs may also be classified on the basis of the time or accounting period they are to be charged
against revenue. Some costs are first recorded as assets and then expensed as they are used or expired.

Page 3 of 15
Other costs are immediately expensed in the year of incurrence. Product costs and periodic costs are
the two categories according to this classification.
Product costs: are costs directly and indirectly identifiable with the product. These costs provide no
benefit until the product is sold and are therefore inventoriable, i.e. it is part of the finished product.
Product costs are added to units of product (i.e., "inventoried") as they are incurred and are not treated
as expenses until the units are sold. This can result in a delay of one or more periods between the time
in which the cost is incurred and when it appears as an expense on the income statement. Product costs
are also known as inventoriable costs.

Periodic costs: are neither directly nor indirectly related to the product. They are expensed (charged
against revenue) immediately and are therefore non- inventoriabl. All selling and administrative costs
are typically considered to be periodic costs. These costs are also called non-inventoriabl costs.
Product costs become periodic cost when products are sold.
6. Relationship of the cost to volume of production
Taking the response of a cost to changes in production volume as a base we can classify costs into
variable, fixed, and mixed.
Variable costs: are costs that change in direct proportion to changes in volume of output, whereas the
unit cost remains constant. Variable costs are easily traceable to units of output and are controlled by
the department head responsible for incurring them.
Fixed cost: are costs remain constant over a relevant range of output, whereas the fixed cost per unit
varies inversely with output. Relevant range is the range over which total fixed costs remains constant.
But beyond the relevant range, the fixed costs will change in total. Thus, fixed costs will not be
affected immediately by changes in the output (cost driver). These costs are usually controlled by top
management.
Mixed costs: These are costs that contain both fixed and variable characteristics over various relevant
ranges of operation. Telephone bill can be an example.
For costs to be variable, fixed or mixed, they must have a linear relationship to production in units (or
some other measure of activity-output is by far the most commonly used activity measure). The
following table summarizes unit costs and total costs:
As output increases:
In Total Unit Cost
Variable Cost ....................Increases Remains Constant
Fixed Cost..........................Remains Constant Decreases
The challenge of identifying costs as variable or fixed (or mixed) is common to many cost accounting
issues. In many real-world situations, approximations can be made without much loss in benefit. We
will discuss variable, fixed and mixed costs in detail latter.
7. The ability to be traced
A cost may be classified as direct and indirect based on management ability to trace it to specific jobs,
departments and units or generally to specific cost objects.
Direct costs: are costs that management is capable of tracing them to specific items or areas in an
economically feasible way. These are costs that could be traced to specific units in a cost-effective
manner. Direct material and direct labor costs are example of direct cost of products.
Indirect costs: are costs that are common to many items and are therefore not directly traceable to any
specific item (cost object). These costs are usually charged to items (cost objects) through allocation
techniques. For a product indirect material, indirect labor, other FOH costs are indirect costs. There are
two reasons why a cost would be considered indirect: either it is impossible or it is impractical to trace
the cost to the cost object.

Page 4 of 15
 For example, it is impossible to trace the factory managers’ salary in a multi-product plant to any
particular product made in the plant. Even if a product were dropped entirely, we would ordinarily
expect the factory manager’s salary to remain the same. This is an example of a "common cost".

On the other hand, other costs are treated as indirect costs because it would not be practical to treat
them otherwise. For example, it would be possible to measure the precise amount of varnish used on
each armchair produced at a house furniture factory, but it wouldn’t be worth the effort. Instead,
varnishes would typically be considered an indirect material and would be included in overhead.

Note that a cost that is not direct with respect to a product may be direct with respect to another cost
object such as a department. For example the salary of a production department's manager is not direct
with respect to a product but it is a direct cost for the production department. In general the
classification of a certain cost item as direct or indirect is affected by the following factors:
a) The materiality of the cost in question:
For costs that are immaterial, tracing will not be cost effective (or not as such relevant) even if the cost
has direct relation with cost object. For example, glues and invoice papers sent with the product
usually are classified as indirect (not traced) as they are immaterial.
b) Available information-gathering technology:
Improvements in the information technology will make cost tracing simpler and more cost effective
and make more costs to be direct.
c) The cost object selected:
For example, consider the salary of supervisor in the maintenance department of a textile factory. If
the cost object is the department, the supervisor’s salary is a direct cost. In contrast, if the cost object is
a service (product), the supervisor’s salary is an indirect cost. Thus, a particular cost may be
simultaneously be direct and indirect, depending on the type of cost objective/object.
8. Relationship of cost to planning, controlling, and decision making
Every decision involves choosing from among at least two alternatives. Only those costs and benefits
that differ between alternatives are relevant in making the selection.
A. Relevant and Irrelevant Costs
A relevant cost is a future cost that differs among alternatives. Relevant costs also are called
differential or incremental costs. Restricting attention to relevant costs greatly simplifies the decision
making process. When deciding among alternatives, only those costs and revenues that change need
be considered. Managers appreciate simplified reports that include only the information they need to
make decisions. An irrelevant cost is one that is the same for all decision alternatives. These costs
need not to be considered.
A direct or variable cost is not necessarily a relevant cost. For example, direct material is a variable
cost and is a direct cost with respect to output in units. But in a decision concerning whether to
increase automation to reduce direct labor in the production process, direct material is not a relevant
cost. The amount of material per unit is the same regardless of how units are produced.
B. Controllable and Uncontrollable Costs
Controllable costs are those which may be directly influenced by unit managers in a given time period.
Non-controllable costs are those costs which are not directly administered at a given level of
management authority.
Primarily used for the evaluation of the segment management, this classification seeks to separate
costs into those that can be influenced by management, and those that cannot be. Managers perceive
the evaluation process to be more fair if they are evaluated only over those activities and costs they

Page 5 of 15
can influence. For example, depreciation on existing equipment is not controllable because the cost of
the equipment is sunk. Again, a controllable cost is not necessarily direct or variable.
C. Standard and Budgeted costs:
Standard costs are those costs which should be incurred in a particular production process under
normal conditions. Standard costing is usually concerned with per-unit costs of direct material, direct
labor and FOH, whereas budgeted costs usually provide forecasted activity on a total cost basis.
D. Opportunity Costs.
An opportunity cost is the potential benefit that is given up by selecting one alternative over another.
An opportunity cost is not an actual expenditure and it is rarely (if ever) shown on the accounting
books of an organization. It is, however, a cost that must be considered in decisions.
E. Sunk 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. Since sunk costs cannot be changed and therefore cannot be differential costs,
they should be ignored in decision-making. While students usually intellectually accept the idea that
sunk costs should be ignored, they often have difficulty putting this idea into practice. A sunk cost is
an amount of cash that has been spent and it cannot be recovered. For example, if you are considering
selling a used car, the amount you paid for it two years ago is sunk. It should not influence the amount
you accept when you sell the car. The value of a used car is set by the market. There is an active
market for all types of used cars. A sunk cost is by definition irrelevant because it cannot differ across
decision alternatives. The two alternatives here are: (1) sell the car, or (2) keep the car. The amount
paid for the car in the past is the same either way and cannot influence the decision.
F. Shutdown costs: - are fixed costs that would be incurred even if there were no production.
G. Committed Vs Discretionary costs.
Committed costs are costs that will continue even if an organization shuts down for a short time.
These costs cannot be eliminated without endangering an organization's overall health and existence.
Examples are the cost of facilities and top management. Discretionary costs are costs that exist as the
result of a management decision. In comparison with committed costs, such costs are more easily
changed in bad economic times without doing serious long-run harm to the entity. Examples are a
training program, an advertising campaign, and corporate contributions.
1.2.2 Cost Behavior
Cost behavior refers to how the activities of an organization affect its costs. For example, if one or
more patient is added (admitted) for a 3-day stay, the costs of a hospital changes. Addition of one
more flight to the schedule will affect the cost of airlines. A decision to add one program by
educational institution will affect its costs. An increase in one unit of output will affect the total costs.

Knowledge of the patterns of cost behavior offers valuable insights in planning and controlling short-
and long-run operations.
The behavior of costs is depicted in the following graphs. Figure 1 shows that variable costs change as
activity level changes. Figure 2 shows that fixed costs remain constant, in total, over a certain range.
Figure 3&4 shows the characteristics of mixed costs.

Page 6 of 15
Figure 1 Figure 2 Figure 3 Figure 4

C C C

Q Q Q Q
Variable Fixed Semi-variable Semi-Fixed
(Step) costs

1.3 Identifying work flow of a manufacturing firm

Work flow
A firm’s cost accounting system parallels its flow of operations. The steps in a typical cycle of
operations of a firm that makes and sells its own products are outlined below.
Procurement: Raw materials and supplies needed for manufacturing and ordered, received, and
stored. Direct and indirect factory labor and services are obtained.
Production: Raw materials are transferred from the storeroom to the factory labor, tools, machines,
power, and other costs are applied to complete the product.
Warehousing: Finished goods are moved from the factory to the warehouse to be held until they are
sold.
Selling: merchandise is shipped from the warehouse
1.4.1 Matching Cost Flow and Work flow
1. Procurement
Purchases of materials, labor, and overhead are recorded as debits to raw materials, factory
payroll clearing and manufacturing overhead control. As these costs are used, or applied, in
factory operations, they are credited to these accounts and transferred to production.
2. Production
Costs of materials, labor, and overhead transferred in to production are debited to work-in-
process. As goods are finished and moved from the factory floor, their cost is removed from
the work-in-process account by a credit entry and charged (debited) of finished goods.
3. Warehousing
The cost of finished goods transferred from work-in-process is recorded as a debit to finished
goods. The cost of merchandise shipped from the warehouse to customers is credited to
finished goods sold and debiting income summary.
4. Selling
As finished goods are sold and shipped from the warehouse, their cost is debited to cost of
goods sold. At the end of the accounting period, this account is closed by crediting cost of
goods sold and debiting income summary.
The matching of cost and workflow is shown below.

Page 7 of 15
 Procurement Production Warehousing Selling

Raw materials Work-in-process Finished goods Cost of goods sold

IN OUT IN OUT IN OUT IN OUT

Factory payroll clearing Income summary

IN OUT IN
OUT

Manufacturing over head control

IN OUT

Of the four steps in the operating cycle, production is probably the most complicated to account for
and to control.

Recording Cost Flows

There are eight common transactions in a typical job order costing system.
1. When raw material are purchased:
Raw materials……………………………….xxx
Voucher payable…………………………..xxx
2. When raw materials are used:
Work-in-process…………………………….xxx
Manufacturing overhead control…………….xxx
Raw materials…………………………….xxx
3. When factory wages are earned:
Factory payroll clearing………………………xxx
Salaries and wages payable………….. ……xxx
4. When labor is charged to operations:

Work-in-process………………………………xxx
Manufacturing overhead control………………xxx
Factory payroll clearing…………………….xxx
5. When other manufacturing overhead costs are incurred:

Manufacturing overheads cost applied………..xxx

Voucher payable and other accounts………xxx
6. When factory overhead costs are transferred to work in process inventory account:
Work-in-process………………………………xxx
Manufacturing overhead control…………..xxx

7. When finished goods are transferred from factory to the store:

Page 8 of 15
 Finished goods…………………………………xxx
Work-in-process……………………………xxx

8. When finished products are sold:

Cost of goods sold……………………………...xxx

Merchandise inventory…………………….xxx

Page 9 of 15
 1.3.2 Flow of Costs in a Manufacturing Enterprise
Cost accounting consists of a system which is concerned with precise recording and measurement of
cost element as they originated and flow through the production processes. This flow is illustrated in
the following diagram.

Cash and Cost of materials * Material

Other Assets Pay for Purchased held in
inventory

Pay for Requisitioned to

Other Manufacturing costs

- DL * Work in process
- FOH Inventory
-heat, light power -DM
- Insurance -DL
Expended (applied) to
- Depreciation. - FOH
- Property tax
- Etc

Cost of goods
*Finished goods manufactured
Cost of goods sold inventory

Where * shows an inventory account

Cost accounts are expansion of general accounts and are related to general accounts. The general
accounts include accounts such as cash, account receivable (A/R), account payable (A/P), equipment,
accumulated deprecation and the like. Cost accounts included materials, payroll account, work in
process, factory overhead control, finished goods, etc.
Example: 1
To illustrate the flow of cost, consider the following transactions for a company and pass the necessary
journal entries assuming perpetual inventory system is used.
a. Materials purchased on account $140,000
b. Materials requisitioned:
Direct…………..$85,000
Indirect…………$15,000
Page 10 of 15
 c. Total payroll of the company for a period $ 180,000. Payroll was paid after deducting 12%
income tax and 7% pension contribution.
d. The distribution of the payroll was:
Direct labor…………..60% Marketing Department…………….18%
Indirect labor…………15% Administrative Department...……..7%
e. Other factory overhead consists of:
Depreciation……………$8,500
Insurance Expired………$1,200
Others general factory overhead costs $26,340, 70% paid in cash.

f. Factory overhead accumulated in FOH control account was transferred to the work in
process account.
g. Work completed and transferred to finished goods $120,000
h. Sales for the period total $100,000, 40% received in cash and 75% of the sales price
represents cost of goods sold.

Example: 2
The following data belong to a company for a period.
 Materials used $10,000 (80% for DM)
 Labor used 50,000(70% for DL)
 FOH cost (others) 5,000 (Heat, Light, Power)

Instruction: Compute: A. prime cost B. Total FOH cost

C. Conversion cost
D. Production cost (mfg)
E. Direct cost F. Indirect cost
1.3 REPORTING THE RESULTS OF OPERATIOINS

The results of operations of a manufacturing enterprise are reported in the financial statements. These
statements summarize the flow of costs, revenues and show the financial position at the end of the
period of operations.
1. Income statement:
An income statement is a financial statement, which shows the result of operations in
terms of profit or loss for a period of time by summarizing revenues, costs and
expenses. The manufacturing costs for a fiscal period are reported in the form of a
summary total in the cost of goods sold section of the Income Statement as shown
below:
ABC Company
Income Statement
For the year ended December 31, 2002

Revenue:
Sales…………………………………………………………………………...XXX
Less Cost of goods sold……………………………………………………………XXX
Gross profit………………………………………………………………………XXX
Operating expenses
Selling expense………………………………………….XXX
General expense…………………………………………XXX
Total operating expenses………………………………………………………….XXX

Page 11 of 15
 Net income before income taxes (Net loss)……………………………………….XXX
 The details supporting the cost of goods sold will be shown in the statement of cost of
goods sold as shown below:
Note:
1. Statement of cost of goods manufactured is the statement that shows the cost of goods
manufactured during the period.
2. Statement of Cost of goods sold (CGS schedule)-is the continuation of the statement of cost
of goods manufactured and shows the cost of product sold during a period.
ABC Company
Cost of Goods sold schedule
For the year ended December 31, 2002

Raw material inventory beginning……………………………..$XXX

+ Raw material purchase during the period (net)……………….XXX
Raw materials available for use………………………….……..$XXX
- Raw materials ending…………………………….…….……. XXX
Raw materials used (consumed………………………….……. $XXX
- Indirect materials used… …….……………………..………. XXX
DM used…………………………… …………………….…….…... XXX
+Direct labor used………………………………… ………………….XXX
+FOH applied…………………………….……………………..……..XXX
Total manufacturing cost……………………………………….………… $XXX
+WIP beginning………………………………………………………………XXX
Cost of goods that have been in process during the period…………….……..XXX
-WIP ending………………………………………………………….……… XXX
Cost of goods manufactured during the period…………………….……….. $XXX
+Finished goods inventory beginning………………………….…………….. XXX
Cost of goods available for sale…………………….………………..……. $XXX
-Finished goods inventory ending……………………………….………….. XXX
Cost of goods sold………………………………………………….……… $XXX

From this cost of goods schedule we can develop a number of relationships:

For example:
1. Raw material available for use = Raw materials inventory beginning + Net raw materials purchased
during the period.
But net raw materials purchased during the period = Raw materials purchased – purchase returnes and
allowances – purchase discount
2. Direct material used = Raw materials available use – Raw material ending –Indirect materials used.
Or = Total raw materials used – Indirect materials used.
3. Total manufacturing cost = Direct material used + Direct labor + Factory overhead applied.
4. Cost of goods manufactures during the period = Total manufacturing cost + work in process
beginning – work in process ending etc.
2. Balance Sheet
Balance sheets of manufacturing enterprises differ from non-manufacturing organizations because
they report three kinds of inventories: Raw materials, work in process and finished goods.

Page 12 of 15
Example 1
The following information appeared in the financial statements of ABC Company on 31 st December
2004.
Cost of goods manufactured …………………………$405,000
Cost of direct materials used…………………………. 160,000
FOH, 80% of direct labor cost……………………….. 92,000
Work in process (ending)……………………………… 48,000
Required: Compute: work in process on January 1, (at the beginning of the year)
Example 2
Assume all the data in Example 1 above and the following additional information for ABC Company.
o Direct materials (beg)…………………………………………. $80,000
o Direct materials purchased…………………………………….$270,000
o Finished Goods (F.G) available for sale and………………….$500,000
o Finished goods inventory (ending)…………………………….$120,000
Required: - prepare the cost of goods sold schedule.

Example 3

A fire completely destroyed a plant and its contents on February 26th. Fortunately certain accounting
records were kept in another building. They revealed the following for 31st December 2002 to
February 26th2004.
Sales…………………………………………………………$500,000
Direct labor cost…………………………………………… 180,000
Prime cost……………………………………………………..294,000
Gross profit rate………………………………………………….. 20%
DM purchased…………………………………………………160,000
Cost of goods available for sale……………………………….450, 000
DM (12, 31, 2002)……………………………………………..160,000
WIP (12, 31, 2002)……………………………………………..34, 000
F.G (12, 31, 2002)……………………………………………...30, 000
FOH 40% of conversion cost………………………………….. ?
Instruction: Compute the cost of
a) DM inventory lost by fire
b) WIP inventory lost by fire
c) F.G inventory lost by fire

Example 4
On June 30, 1999 flash flood damaged the warehouse and factory of XYZ Corporation, Completely
destroyed the work in process inventory. There was no damage to either the materials or finished
goods inventories. A physical inventory taken after the flood revealed the following valuations.
Direct materials Inventory...…………. $47,500
WIP inventory ………………………..0
Finished goods inventory……………. $45,000
The inventory on Jan 1, 1999, consisted of the following:
Finished goods……………………………………$184,000
Work in process…………………………………. 80,000
Direct materials………………………………….. 50,000
A review of the books and records disclosed that the gross profit margin historically approximated
25% of sales. The sales for the first six months of 1999 were $340,000. Direct materials purchases

Page 13 of 15
were $115,000. Direct labor cost for this period was $100,000; factory overhead has historically been
applied at 50% of direct labor.
Required: Calculate the value of the work in process lost at June 30, 1999

1.5 Common cost related terminologies

A cost system typically accounts for costs in two basic stages:
Stage 1.It accumulates costs by some “natural” classification such as: Materials, labor, fuel,
advertising, etc. Manufacturing costs are accumulated as labor, materials and factory
overhead.
Stag 2.It assigns these costs to cost objects.
Cost accumulation is the collection of cost data in some organized way (such as material, labor, fuel,
etc) through accounting system.
 Cost assignment is the general term that encompasses both tracing and allocating
accumulated costs to a cost object. Cost tracing is the assigning of direct costs to the chosen
cost object, and cost allocation is the assigning of indirect costs to the chosen cost object.
Direct costs are costs that are related to the particular cost object whereas indirect costs are
costs that are common to two or more cost objects. Cost assignment is a general term that
include both:

1. Tracing accumulated costs to a cost object.

2. Allocating accumulated costs to a cost object.
Costs that are traced to cost object are direct costs and costs that are allocated to a cost object are
indirect costs.

Cost Object: Any thing for which a separate measurement of costs is desired. To guide decisions,
managers often want to know how much a certain thing (such as a new product, a machine, a service,
or a process) costs. All these things are called cost objects.
Cost Tracing and Cost Allocation
 Cost tracing: is the assignment of direct cost to the chosen cost object.
 Cost allocation: is the assignment of indirect costs to the chosen cost object.

Direct
Cost Cost Tracing
Cost Cost Object
Assignment
Indirect
Cost Cost allocation

Page 14 of 15
Cost, Expense, and Loss

Cost accounting involves the use of, the control of, and the planning of costs. The term cost differs
from expense and loss, as seen by their definitions:
A) Cost: The benefit given up to acquire goods or services, measurable in money terms by the
reduction of assets or the incurrence of liabilities.
B) Expense: A cost that has given a benefit and is now expired. When the benefits (goods or
services) are received, the cost becomes an expense. In contrast an unexpired cost is
classified as an asset because benefits are still to be received.
C) Loss: A cost that occurs when goods or services purchased are determined valueless
without having provided any benefit. This loss appears as a deduction from
revenues. Expenses and losses both reduce revenue, but are separately disclosed to
highlight the loss.

Page 15 of 15