CHAPTER TWO

INTRODUCTION TO COST TERMS AND CLASSIFICATIONS

Introduction
Dear learners, we would say well come to the second chapter for the course of “Cost and Management
accounting I”. The main objectives of this chapter address the cost terminologies, concepts,
classifications and purposes of cost in different business organizations. Contextually the costs
classifications undertaken in the manufacturing, merchandising and service sectors expressed in
accordance to the functions performed the businesses.

In this chapter mainly emphasizes the distinctions between product costs and period costs. As we
know that the product costs are composed of the three elements of the manufacturing costs namely,
the direct material, the direct labor, and the manufacturing overhead. Normally those costs are treated
as an asset up to the units of the product is sold and reported on the statement of the financial position
as an inventory under the caption of “assets”. Whereas period costs are costs that are incurred in
generating revenue of the period, and hence presented on the Statement of Comprehensive Income
accounts as an expense of the fiscal period.
LEARNING OBJECTIVES
After completing this chapter, you should be able to:
 Define and illustrate costs and cost objects
 Distinguish between direct costs and indirect costs
 Explain variable costs and fixed costs
 Interpret unit costs cautiously
 Distinguish the product costs from the period costs
 Explain why product costs are computed in different ways for different purposes
 Describe a framework for cost accounting and cost management
2.1. Cost Terminologies and Classifications
2.1.1. Cost Terminologies
Most of the accounting reports incorporates several cost and management terminologies. Although
understanding the different cost terminology is essential at least for the following two reasons.
 It enables accounting information users to best use of information provided.
 Use of common terminology, avoids confusion and misunderstanding among users

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2.1.2. Costs, Expense and Loss
One of the common confusions in this regard is the distinction between costs and expenses. Many
people use costs and expenses interchangeably. Thus, we start with the definition of costs and
expenses.

The term cost defines with different terminologies in different professions even though the main
essence would be similar in its contexts. Accountants define cost “as a resource sacrificed or forgone
to achieve a specific objective.” A cost may be direct materials or advertising incurred costs and
usually measured in monetary amount that must be paid to acquire goods or services. In this context
costs as an actual cost that is the incurred cost as like a historical or past cost, and also as budgeted
cost, which is a predicted or forecasted cost (a future cost).
1. Costs: Costs are all disbursements that are incurred in the course of producing the products or for
the acquisition of assets in the course of generating revenue. For instance, purchase of raw
materials represents a cost as the raw material is used to produce finished goods that generate
revenue when sold. From the above definition, we can also understand that all disbursements do
not represent costs. For example, the payment of dividend is a disbursement but it does not help
generate revenue. Hence, dividend is not a cost. All costs initially represent assets. As the assets
are used in generating revenue, the amount consumed becomes an expense.

2. Expenses: Expenses are defined as the costs of the assets used or consumed in the process of
generating revenues. Expenses are also defined as the expired costs resulting from a productive
usage of assets. Expenses are the costs which are applied against revenue of a particular
accounting period in accordance with the principle of matching costs with revenues. In other
words, expenses are that portion of the revenue earning potential of assets which have been
consumed in the generation of revenues. They do not generate future benefit. They are payments
of resource for the current and past period benefit. Expenses used in the process of income
determination of the organization over a given period.
For instance, Insurance premiums paid in advance to serve the coming period are initially
recognized as assets, but as time passes on the asset continually change into an expense. Another
example may be a motor vehicle bought for use for the coming five years is an asset when initially
purchased. However, as the asset is used up in the process of generating revenue, the cost
gradually becomes an expense. Thus, expenses are expired costs, or costs used up in the course
of generating revenue. The figure below may show the distinction between costs and expenses.

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 Costs

Expired Costs Unexpired Costs

Expenses Losses

Assets

Shown in the
Statement of Shown in the
comprehensive balance sheet as
income on the debit assets
side
Note: Costs refer to expenditures incurred in order to generate revenue. When these expenditures are
actually used up, they become expenses. Thus, costs represent future economic benefits and hence
are assets. Expenses are costs that are used and do not have future economic benefit.
3. Loss: Loss is defined as reduction in a firm’s equity, other than from withdrawal of capital for
which no compensating value has been received. A loss is unexpired cost resulting from the
decline in the service potential assets that generated no benefit to the firm. Obsolescence or
destruction of stocks by fire is examples of loss.
The distinction between cost and expenses is important for the preparation of financial statement for
service, merchandising and manufacturing firms. In fact, it has more importance relatively for
manufacturing enterprise. This is because, costs incurred in the manufacturing process don’t become
expense until the product is sold and thus, items that are fully or partially manufactured represent
costs and should be recognized as assets on the statement of financial positions. Therefore, financial

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reporting in manufacturing firms has some complication as compared to financial reporting in the
service and merchandising business.
2.1.3. Cost Objects and Cost Drivers
When you think of cost, you invariably think of it in the context of finding the cost of a particular
thing. We call this thing a cost object, which is anything for which a measurement of costs is desired.
In manufacturing company, the cost object is the unit of finished goods manufactured.
Cost Accumulation and cost Assignment: A costing system typically account for costs in two basic
stages, accumulation followed by assignment. Cost accumulation is the collection of cost data in some
organized means of accounting system and cost assignment is a general term that encompass both (1)
tracing accumulated cost that have direct relationship to the cost object and (2) allocating accumulated
costs that have an indirect relationship to the cost object. For example, a publisher that purchase paper
rolls for printing magazines collect the cost of paper bought and used in any one month to obtain the
total monthly cost of paper used. Beyond accumulating costs, the cost accountant assign cost to the
different magazines the publisher publishes to help decision making.
Cost driver: is any factor that affects total cost. That is a change in the cost driver will cause a change
in the level of the cost of a related cost object. For example, the following are some of the cost drivers
used for each types of costs mentioned.
 Mile driven for transport cost
 Length of time of call for telephone cost
 Metric cube of water consumed for water cost
 Unit sold for cost of goods sold
Cost management: cost management is the essence of cost accounting. Cost management refers to
the planning and execution of activities both in the short run and long run to control costs. Profoundly,
cost management is about cost reduction but it is not confined to it alone. Sometimes managers may
incur additional costs in order to increase their future sales. This activity is also a cost management.
It is the set of actions that a manager takes to satisfy customers while continuously reducing and
controlling cost. Cost reduction efforts frequently focus on two key areas:
 Doing only value adding activities, that is, those activities that customers perceive as adding
value to the product or service they purchase.
 Efficiently managing the use of the cost drivers in the value adding activities.

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 Activity 2.1
1. What is the difference between cost, expense and loss?
________________________________________________________________________
_______________________________________________.
2. What is the difference and similarities between loss and expenses?
________________________________________________________________________
________________________________________________________________________
3. What are the differences actual costs and budgeted costs?
________________________________________________________________________
____________________________________.
4. What is the distinction between the cost objects and cost drivers?
________________________________________________________________________
_______________________________.

2.2. Cost classifications

Dear Learner, what are the different classifications of cost? Please justify how managers classify
costs and what would be the basis for the cost classifications.
Cost may be classified into different categories depending upon the purpose of classification. Some
of the important categories in which the costs are classified are as follows:
1. Direct Costs and Indirect Costs
We now describe how costs are classified as direct and indirect costs and the methods used to assign
these costs to cost objects.
a. Direct costs of a cost object related to the particular cost object and can be traced to it in an
economically feasible (cost-effective) way.
In the process of manufacturing of production of articles, materials purchased, laborers
employed and the wages paid to them.
Certain other expenses also incurred directly.
All direct costs take an active and direct part in the manufacture of a particular commodity
and hence are called direct costs.
b. Indirect costs of a cost object related to the particular cost object but cannot be traced to it
in an economically feasible (cost-effective) way.
For example, salaries of timekeepers, storekeepers and supervisors. In addition, certain expenses
incurred for running the administration are the indirect costs. All of these cannot be conveniently
allocated to production and hence are called indirect costs.
The term cost allocation is used to describe the assignment of indirect costs to a particular cost object.
Cost assignment is a general term that encompasses both (1) tracing direct costs to a cost object and
(2) allocating indirect costs to a cost object.

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2. Cost-Behavior Patterns: Variable Costs and Fixed Costs
Costing systems record the cost of resources acquired, such as materials, labor, and equipment, and
track how those resources are used to produce and sell products or services. Recording the costs of
resources acquired and used allows managers to see how costs behave. Consider two basic types of
cost-behavior patterns found in many accounting systems.

A variable cost changes in total in proportion to changes in the related level of total activity or
volume. A fixed cost remains unchanged in total for a given time period, despite wide changes in the
related level of total activity or volume. Costs are defined as variable or fixed with respect to a specific
activity and for a given time period.

a. Fixed cost: Fixed cost is a cost, which does not vary but remains constant within a given
period of time and a range of activity in spite of the fluctuations in production. In other words,
fixed costs are the costs, which will remain same whether there is increase or decrease in size
of production. Like costs of Rent, insurance, salary and others will remain fixed at all levels
of production. However, it does not mean fixed cost remains fixed forever. It also changes
after the specific level of production. The cost, which does not vary proportionately but
simultaneously does not remain stationary at all times, is known as semi-variable cost. It can
also be named as semi-fixed cost. Some examples of such costs include among the other
depreciations, repairs etc...
For example, a carpenter who manufacture wood product incurs Birr2,000 rent expense monthly.
This expense remains constant regardless of the number of tables or chairs produced in a given
relevant rang.

Number of tables Rent per month (In Birr) Rent per table (In Birr)
1 2,000 2,000
5 2,000 200
10 2,000 100
50 2,000 20
100 2,000 10

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 Y
Cost in Br, Y

Cost in Br,
Total fixed cost Total Fixed Cost per Unit

Volume of production X Volume of production

The characteristics of fixed costs are:
a. Fixed in their total amount within a relevant range of output.
b. Increase or decrease in per unit fixed cost when the quantity of production changes;
c. Apportioned to department on some arbitrary basis;
d. Such cost can be controlled mostly by top-level management

b. Variable cost: Variable costs are those costs that vary in total as the volume of activity
changes; the total dollar amount rise, when the volume of activity increases, and falls when
the volume of activities goes down. However, the unit cost remains the same. For instance, a
shoes manufacturer needs ties for its shoes. The number of ties required depends on the
number of shoes manufactured. For instance, if two ties of shoes are required for a pair of
shoes, then for two pairs of shoes, four ties are required, for three pairs of shoes, six ties are
needed. Assuming that one pairs of shoes needs two ties and one tie costs Birr 2.00, the
following table shows a comparison between the total cost and total pairs of shoes
manufactured.
Volume of activity Total ties required Cost of Total Ties (Br)
(Pairs of Shoes)
1 2 Br 4,000.00
2 4 8,000.00
3 6 12,000.00
4 8 16,000.00
Generally, Variable costs show the following characteristics:
a. Variability of the total amount in directly proportion to the volume of output;
b. Fixed amount per unit in the face of change volume;
c. Easy and reasonably accurate allocation and apportionment to departments;
d. Such cost can be controlled by functional managers

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Y Y

Cost in Br.

Cost in Br.
Variable Cost per unit
Total Variable Cost

X X
Volume of production Volume of production

Relevant Range: Relevant range is the band of normal activity level or volume in which there is a
specific relationship between the level of activity or volume and the cost in question.
For example, a fixed cost is fixed only in relation to a given wide range of total activity or volume (at
which the company is expected to operate) and only for a given time span (usually a particular budget
period).
c. Semi-Variable Costs or Semi- Fixed Costs (Mixed costs) or total costs: A semi-variable cost,
also known as a semi-fixed cost or a mixed cost, is a cost composed of a mixture of both fixed
and variable components. Costs are fixed for a set level of production or consumption, and
become variable after this production level is exceeded.
For example, the introduction of additional shift in the factory will require additional supervisors and
certain costs will increase by steps. Another example is, in the case of a telephone connection, there
is a minimum rent and beyond a specified number of calls, the charges vary according to the number
of calls made. In fact, there is no definite pattern of behavior for semi-variable costs.

3. Classification of costs on the basis of functions

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 a. Production cost: The production cost is the cost, which occurred on the conversion of raw
material into finished product, or we can say that it the cost incurred on the sequence of
production.
b. Administration cost: The cost for formulating the policies, directing the organization, and
controlling the operations of undertaking that is not related to direct cost.
c. Selling cost: The cost incurred in promoting sales and retaining customers is called as selling
cost. It also called as marketing cost of the company.
d. Distribution cost: In the present era after production distribution is also very important task
and the expenses incurred for distribution is called as distribution cost.
4. Cost Classifications as Product Costs and Period Costs
a. Product costs- are costs which are a part of the cost of a product rather than an expense of
the period in which they are incurred.
➢ They are included in inventory values.
➢ In financial statements, such costs are treated as assets until the goods they are assigned
to are sold.
➢ They become an expense at that time.
➢ These costs may be fixed as well as variable, e.g., cost of raw materials and direct wages,
depreciation on plant and equipment etc.
b. Period costs- are costs which are not associated with production.
➢ They are treated as an expense of the period in which they are incurred.
➢ They may also be fixed as well as variable.
➢ They are charged against the revenue of the relevant period.
➢ Such costs include general administration costs, salaries salesmen and commission,
depreciation on office facilities etc.
Differences between opinions exist regarding whether certain costs should be considered as product
or period costs. Some accountants feel that fixed manufacturing costs are more closely related to the
passage of time than to the manufacturing of a product. Thus, according to them variable
manufacturing costs are product costs whereas fixed manufacturing and other costs are period costs.
However, their view does not seem to have been yet widely accepted.
5. Relevant and Irrelevant Costs
a. Relevant costs: are those which change by managerial decision. For example, if a
manufacturer is planning to close down an unprofitable retail sales shop, this will affect the

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 wages payable to the workers of a shop. This is relevant in this connection since they will
disappear on closing down of a shop.
b. Irrelevant costs: are those which do not get affected by the decision. For example, prepaid
rent of a shop or unrecovered costs of any equipment which will have to be scrapped are
irrelevant costs which should be ignored.
6. Controllable and Uncontrollable Costs
a. Controllable costs -are those costs which can be influenced by the ratio or a specified member
of the undertaking.
b. Uncontrollable Cost - are costs that cannot be influenced a given level of management or a
specified member of the undertaking.
A factory is usually divided into a number of responsibility centers, each of which is in charge of a
specific level of management. The officer in charge of a particular department can control costs only
of those matters which come directly under his control, not of other matters. For example, the
expenditure incurred by tool room is controlled by the foreman in charge of that section but the share
of the tool room expenditure which is apportioned to a machine shop cannot be controlled by the
foreman of that shop. Thus, the difference between controllable and uncontrollable costs is only in
relation to a particular individual or level of management. The expenditure which is controllable by
an individual may be uncontrollable by another individual.
7. Avoidable Costs and Unavoidable Costs
a. Avoidable costs - are those which will be eliminated if a segment of a business (e.g., a product
or department) with which they are directly related is discontinued. For example, the salary
of a factory manager or factory rent cannot be eliminated. It will simply mean that certain
other products will have to absorb a large amount of such overheads.
b. Unavoidable costs - are those which will not be eliminated with the segment. Such costs are
merely reallocated if the segment is discontinued. For example, the salary of people attached
to a product or the bad debts traceable to a product would be eliminated. Certain costs are
partly avoidable and partly unavoidable. For example, closing of one department of a store
might result in decrease in delivery expenses but not in their altogether elimination.
8. Classification of costs on the basis of decision-making.
a. Shutdown cost-are costs during the period when a manufacturer or an organization may have
to suspend its operations for a period on account of some temporary difficulties, e.g., shortage
of raw material, non-availability of requisite labor etc. During this period, though no work is
done yet certain fixed costs, such as rent and insurance of buildings, depreciation, maintenance
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 etc., for the entire plant will have to be incurred. Such costs of the idle plant are known as
shutdown costs.
b. Sunk costs - are historical or past costs. These are the costs which have been created by a
decision that was made in the past and cannot be changed by any decision that will be made
in the future. Investments in plant and machinery, buildings etc. are prime examples of such
costs. Since sunk costs cannot be altered by decisions made at the later stage, they are
irrelevant for decision-making.
Activity 2.2
1. What is the difference between the relevant costs and irrelevant costs?
________________________________________________________________________
________________________________________________________________________
_______________________.
2. What are the three manufacturing costs?
________________________________________________________________________
________________________________________________________________________
______________________________.
3. Explain the differentiate between variable and fixed costs
________________________________________________________________________
________________________________________________________________________
_____________________________.
4. Define the following two contrasting words of cost categories.
i. Product versus Period costs
________________________________________________________________________
___________________________.
ii. Prime versus Conversion costs
________________________________________________________________________
______________________________.
iii. Controllable versus Non-controllable costs
________________________________________________________________________
_____________________________________.
2.3. Other Cost Related Terminologies
1. Total cost and Unit cost
The total cost of a given product is composed of different elements or components of costs such as
direct material, cost direct labor costs, direct and indirect expenses and other related costs.
Accounting systems typically report both total cost amounts and unit cost amounts. A unit cost, also
called an average cost, calculated by dividing total cost by the related number of units. The units
might be expressed in various ways. Knowingly, the unit cost is a total expenditure incurred by a
company to produce, store, and sell one unit of a particular product or service. Unit costs are
synonymous with the cost of goods sold and the cost of sales.

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A company’s financial statements will report the unit cost. These reports are vital for internal
management analysis. The reporting of unit costs can vary by type of business. Companies that
manufacture goods will have a more clearly defined calculation of unit costs while unit costs for
service companies can be somewhat vague.
Example: The Marathon Motor Company delivered packages to assemble the automobiles. Suppose
in 2020, in the first year of operations, Birr40,000,000 of manufacturing costs are incurred to produce
500,000 speaker systems at the main branches of the company site. Then, the unit cost computed as:
𝐓𝐨𝐭𝐚𝐥 𝐦𝐚𝐧𝐮𝐟𝐚𝐜𝐭𝐮𝐫𝐢𝐧𝐠 𝐜𝐨𝐬𝐭𝐬 𝐁𝐢𝐫𝐫𝟒𝟎,𝟎𝟎𝟎,𝟎𝟎𝟎
𝐔𝐧𝐢𝐭 𝐜𝐨𝐬𝐭 = 𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐮𝐧𝐢𝐭𝐬 𝐦𝐚𝐧𝐮𝐟𝐚𝐜𝐭𝐮𝐫𝐞𝐝 = 𝟓𝟎𝟎,𝟎𝟎𝟎𝐔𝐧𝐢𝐭𝐬
=𝐁𝐢𝐫𝐫𝟖𝟎𝐩𝐞𝐫 𝐮𝐧𝐢𝐭𝐬

If 480,000 units are sold and 20,000 units remain in ending inventory, the unit-cost concept helps in
the determination of total costs reported on the Statement of Comprehensive Income accounts and
statements of the financial positions and, hence, the financial results reported by Marathon Motor
Company to shareholders, banks, and the government.
Cost of goods sold in the Statement of Comprehensive Income account, 480,000 units X Birr80 per unit
Birr38,400,000
Ending inventory in the statement of financial positions 20,000 units X Birr80 per unit 1,600,000
Total manufacturing costs of 500,000 units Birr40,000,000
2. Cost Estimation and Cost Ascertainment
Cost estimation is the process of pre-determining the cost of a certain product job or order. Such pre-
determination may be required for several purposes. Some of the purposes are as follows:
1. Budgeting
2. Measurement of performance efficiency
3. Preparation of financial statements (valuation of stocks etc.)
4. Make or buy decisions
5. Fixation of the sale prices of products
Cost ascertainment is the process of determining costs on the basis of actual data. Hence, the
computation of historical cost is cost ascertainment while the computation of future costs is cost
estimation. Both cost estimation and cost ascertainment are interrelated and are of immense use to the
management. In case a concern has a sound costing system, the ascertained costs will greatly help the
management in the process of estimation of rational accurate costs which are necessary for a variety
of purposes stated above. Moreover, the ascertained cost may be compared with the pre-determined
costs on a continuing basis and proper and timely steps be taken for controlling costs and maximizing
profits.
3. Cost Allocation and Cost Apportionment

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Cost allocation and cost apportionment are the two procedures which describe the identification and
allotment of costs to cost centers or cost units. Cost allocation refers to the allotment of all the items
of cost to cost centers or cost units whereas cost apportionment refers to the allotment of proportions
of items of cost to cost centers or cost units Thus, the former involves the process of charging direct
expenditure to cost centers or cost units whereas the latter involves the process of charging indirect
expenditure to cost centers or cost units.
For example, the cost of labor engaged in a service department can be charged wholly and directly
but the canteen expenses of the factory cannot be charged directly and wholly. Its proportionate share
will have to be found out. Charging of costs in the former case will be termed as “allocation of costs”
whereas in the latter, it will be termed as “apportionment of costs.”
2.4. Cost elements of Manufacturing Companies
Categorized business firms as manufacturing, merchandising, and service-Sector Companies
according to their functions to perform the business operations.
We define three sectors of the economy as follows;
1. Manufacturing-sector companies purchase materials and components and convert them into
various finished goods.
2. Merchandising-sector companies purchase and then sell tangible products without changing
their basic form. This sector includes companies engaged in retailing.
3. Service-sector companies provide services (intangible products), for example, legal advice
or audits, to their customer
A cost is composed of three elements, i.e., material, labor and expense. Each of these three elements
may be direct or indirect. The classification of these costs elements as direct and indirect will be
shown as follows;

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 1. Material -the substance from which a product is made is known as material. Material is the
most important element to produce a product. All most 50% of the cost is covered by raw
material used to produce a product. Material is also called as tangible items used in production
e.g. wood used for furniture, cotton for clothes etc. It may be in a raw or a manufactured state.
It can be direct as well as indirect.

a. Direct Material
The material which becomes an integral part of a finished product and which can be conveniently
assigned to specific physical unit is termed as direct material. Direct material costs are the
acquisition costs of all materials that eventually become part of the cost object (work in process and
then finished goods) and can be traced to the cost object in an economically feasible way. Acquisition
costs of direct materials include freight-in (inward delivery) charges, sales taxes, and custom duties.
b. Indirect Material
The material which is used for purposes ancillary to the business and which cannot be conveniently
assigned to specific physical units is termed as indirect material. Consumable stores, oil and waste,
printing and stationery material etc. are some of the examples of indirect material. Indirect material
may be used in the factory, office or the selling and distribution divisions.
2. Labor- refers to human effort such labor (direct as well as indirect) needed and for conversion of
materials into finished goods.
a. Direct Labor
Direct manufacturing labor costs include the compensation of all manufacturing labor that can be
traced to the cost object (work in process and then finished goods) in an economically feasible way.
Examples include wages and fringe benefits paid to machine operators and assembly-line workers
who convert direct materials purchased to finished goods.
b. Indirect Labor
The labor employed for the purpose of carrying out tasks incidental to goods produced or services
provided, is indirect labor. Such labor does not alter the construction, composition or condition of the
product. It cannot be practically traced to specific units of output. Wages of storekeepers, foremen,
timekeepers, directors’ fees, salaries of salesmen etc, are examples of indirect labor costs.
Indirect labor may relate to the factory, the office or the selling and distribution divisions.
3. Other Expenses (expenses)- are those expenses other than materials and labour.
Expenses may be direct or indirect.
a. Direct Expenses

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 These are the expenses that can be directly, conveniently and wholly allocated to specific cost
centers or cost units. Examples of such expenses are as follows:
Hire of some special machinery required for a particular contract
Cost of defective work incurred in connection with a particular job or contract etc.
Direct expenses are sometimes also described as chargeable expenses.
b. Indirect Expenses
These are the expenses that cannot be directly, conveniently and wholly allocated to cost centers or
cost units. Examples of such expenses are rent, lighting, insurance charges etc.
Indirect Manufacturing Costs: All manufacturing costs other than direct materials and direct labor
are classified as indirect manufacturing costs. There are several other titles commonly used to describe
this group of manufacturing costs, including factory overhead, manufacturing overhead or factory
burden. The followings are some of the manufacturing overhead costs for a furniture manufacturing
company:
i. Indirect materials, such as glue, nails, screws
ii. Indirect labor, such as supervisor’s salary and Janitorial services.
iii. Taxes on manufacturing facilities.
iv. Utilities for the manufacturing process.
v. Depreciation on manufacturing faculties.
Prime Costs and Conversion Cost
Prime costs and conversion cost are two other terms used to describe production costs. Prime Costs
are the most important or significant costs traceable to unit of finished product. They include direct
material and direct labor. Conversion costs are those required to convert raw materials into finished
product and consists of direct labor and factory overhead. As noted earlier, the same cost may be
given different titles and used for different purpose. Paper in a copy center, for example, would be
classified as direct material for accounting purposes, but it would also be called a prime cost.
Prime cost = Direct Material Cost + Direct Labor Cost
Conversion cost = Direct Labor Cost + Manufacturing Overhead Cost
2.5. Computation of Costs Information
2.5.1. Direct Material Cost Computation
Direct material costs represent cost of all materials that are integral parts of the cost object like a
product and that can be traced back to the cost object (product for example) in an economically
feasible way. The direct material used in producing product needs a separate computation that shows
the direct material placed into the production process in that period.
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Direct Materials used = Beginning Direct Materials inventory + Direct Materials Purchased –
Ending Direct Materials inventory

For illustration purposes, assume that the direct materials inventory of ABC Furniture Factory
amounts to Birr 248,000.00 as of January 1, 2012, purchases of Birr 880,000.00 and freight costs Birr
3,200.00 is made during the year, and the amount of direct materials inventory at the end of the year
is Birr 234,900.00. The direct material used, therefore, will be shown in the schedule below.

Beginning direct material inventory Br. 248,000.00

Add: Total cost of direct materials purchased:
Direct materials purchased Br. 880,000.00
Freight in 3,200.00
Br. 883,200.00
Direct materials available for use 1,131,200.00
Deduct: Ending direct materials inventory 234,900.00
Direct Materials Used in Production Br. 896,300.00*
*The direct material used in production shows the portion of direct material that have already put in
the production process and the ending direct material cost shows that portion of direct material left in
the store at the end of the period or direct material inventory.
2.5.2. Cost of Goods Manufactured Computation
Cost of goods manufactured refers to those costs that are added in production process and finally
converted into finished goods during a given production period. The cost of goods manufactured,
consists of three cost elements: -
Cost of direct materials used,
Cost of direct labor, and
Manufacturing overhead.
Extending the same example of ABC Furniture Factory, let us assume the cost of direct labor
employed for the year is Birr 875, 000.00, and the following overhead costs are incurred:

Indirect labor Br. 179,200.00

Depreciation on factory equipment 89,200.00
Light and power 87,200.00
Depreciation of Factory building 24,000.00
Insurance expense on factory properties 19,000.00
Property tax 39,000.00
Factory supplies expense 11,600.00
Miscellaneous factory costs 2,200.00
Total overhead Br. 475,400.00

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After the information for the three elements of costs of good manufactured gathered, additional
information about the beginning and ending Work- In -Process are needed. Let us assume farther that
the beginning and ending Work-In-Process inventory costs for ABC Furniture Factory are Br.
220,000.00 and Br.263200.00 respectively. Then the cost of goods manufactured will be calculated
using the following formula.
Cost of Goods Manufactured = beginning work in process inventory + (direct material used +
direct labor incurred + manufacturing overhead) – ending work in process inventory

The computation of Cost of Goods Manufactured for ABC Furniture Factory will take the following
form:
Work in process inventory January 1, 2012 Br. 220,000.00
Add: Direct Materials used* (previous computation.) Br. 896,300.00
Direct labor 875, 000.00
Factory overhead 475,400.00
Manufacturing cost incurred during the year 2,246,700.00
Total work in process inventory during the year (to date) 2,466,700.00
Deduct: Work in process inventory Dec, 2012 263,200.00
Cost of Goods Manufactured Br. 2,203,500.00
2.5.3. Cost of Goods Sold Computation
The cost of goods sold represents the cost of goods that are sold during a given year. The cost of
goods sold is computed using the following formula:
Cost of Goods Sold = Beginning finished good inventory + Cost of goods manufactured –

Ending finished good inventory

Assume that the finished good inventory for ABC Furniture Factory as of the beginning of the year
was Birr 314,000.00, and the ending inventory of finished goods inventory is Birr 364,000.00. The
cost of goods sold is then prepared as follows:

Finished goods inventory, January 1, 2012 Br. 314,000.00

Add: Cost of goods manufactured* 2,203,500.00
Cost of goods available for sale 2,517,500.00
Deduct: finished good inventory Dec.31, 2012 364,000.00
Cost of goods sold Br. 2,153,500.00

2.6. Financial Statements of a Manufacturing Firm

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Financial statements of a Manufacturing Company are more complex as compared to financial
statements of Merchandising and Service companies. Particularly, the statement of financial
positions, and Statement of Comprehensive Income of a Manufacturing enterprise are somewhat
different from their Merchandising and Service counterpart. All costs mentioned above should be
properly accounted for and reported in the financial statements of a manufacturing firm, which is
more complex than that of the Merchandising and Service complements.

2.6.1. Statement of Comprehensive Income of a Manufacturing Firm

Statement of Comprehensive Income of a manufacturing firm differs from statement of
comprehensive income of a merchandising firm by the cost of goods sold caption. A merchandising
firm sells goods that are bought from another merchandising firm or from a manufacturing firm. But
a manufacturing firm sells goods that are internally produced. Hence, the costs of goods sold caption
contains cost of goods manufactured instead of purchase. The amount of purchase can easily be found
from the ledger, but cost of goods manufactured cannot. Cost of goods manufactured must first be
computed before the statement of comprehensive income is prepared.

A Manufacturing firm cannot easily identify the cost of production. Further, there are rooms in a
manufacturing business to make operations more efficient. Therefore, many manufacturing
businesses prepare their statement of comprehensive incomes more frequently than merchandising
businesses to see improvements made through a period. Frequent preparation allows them to know
the results of operation and thereby alter operational strategies.

Assume in the above information of ABC Furniture Factory that the net sales for the year is Br.
3,663,200.00 and total selling expenses Br.660,000.00 and total administrative expenses Br.
337,700.00 and assume there is no income tax.

The following is a sample income statement or statement of comprehensive income of ABC Furniture
Factory (a hypothetical example).

ABC Furniture Factory

Statement of Comprehensive Income
For the year ended Dec.31, 2012
Sales Br 3,663,200.00
Cost of goods sold:
Finished goods inventory, January 1,2012 314,000.00
Cost of goods Manufactured 2,203,500.00
Cost of finished goods available for sale 2,517,500.00
Less finished goods inventory Dec,31,2012 364,000.00
Cost of goods sold 2,153,500.00
Gross profit Br. 1,509,700.00

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 Operating expenses:
Selling expenses 660,000.00
Administrative expenses 337,700.00
Total operating expenses 997,700.00
Net income Br. 512,000.00
The above income statement or Statement of Comprehensive Income is called a single step or
condensed statement of comprehensive income, as it does not show how each element is constructed.
The separate cost computations are inputs to the statement of comprehensive income. It is also
possible to include all the cost computations at a time to prepare the statement of comprehensive
income. Such a statement contains detailed information about each item. The statement in the
following page is a multiple step statement of comprehensive income of ABC Furniture Factory.

ABC Furniture Factory

Statement of Comprehensive Income
For the year ended Dec.31, 2012
Sales Br 3,663,200.00
Less cost of goods sold:
Finished goods inventory, Jan.1,2012 314,000.00
Work in process inventory, Jan.1,2012 220,000.00
Work in process during the year:
Direct materials used:
Direct materials, Jan.1,2012 248,000.00
Direct materials purchased (including freight in) 883,200.00
Direct materials available for use ,131,200.00
Direct materials, Dece.31,2012 234,900.00
Direct material used 896,300.00
Direct labor 875,000.00
Factory overhead:
Indirect labor 197,200.00
Depreciation on factory equipment 89,200.00
Light and power 87,200.00
Depreciation of Factory building 24,000.00
Insurance expense on factory properties 19,000.00
Property tax 39,000.00
Factory supplies expense 11,600.00
Miscellaneous factory costs 8,200.00
Total Factory Overhead 475,400.00
Total manufacturing cost during the year 2,246,700.00
Total work in process during the year 2,466,700.00
Deduct: Work in process, Dece.31,2012 263,200.00
Cost of goods manufactured 2,203,500.00
Cost of goods available for sale 2,517,500.00
Deduct: Finished good inventory, Dece.31,2012 364,000.00
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 Cost of goods sold 2,153,500.00
Gross profit 1,509,700.00
Deduct: Operational expenses:
Selling expenses 660,000.00
Administrative expenses 337,700.00
Total Operational expenses 997,700.00
Net income Br.512,000.00
2.6.2

2.6.2. Statement of Financial Positions of a Manufacturing Firm

The Statement of Financial Positions of a manufacturing firm differs from the statement of financial
positions of a merchandising firm principally by the types of inventories reported. A manufacturing
firm carries three types of inventories namely:
i. Raw Material Inventories: are raw materials in stock and waiting to be used in
manufacturing process.
ii. Work in Process Inventories: are goods partially processed but not yet completed. They are
also called Work in Progress (WIP).
iii. Finished Goods Inventories: are goods fully completed but not yet sold.
Merchandising firms carry only one type of inventory and that is merchandise inventory for sale.
Service firms do not even carry any kind of inventory but supplies to run operations.
Inventory of Direct Material represents the costs of materials that are not yet entered into
the production process.
Inventories of work in process represent all goods that are undergoing some manufacturing
process but yet not done fully to be dispatched for end use. The costs of work in process
inventory include all the manufacturing costs incurred so far in the manufacturing process;
✓ The cost of direct materials,
✓ The costs of labor, and
✓ Applied manufacturing overhead.
The finished good inventory embodies the final product that is not yet sold. The cost of
finished goods inventory includes all manufacturing costs;
➢ Direct material,
➢ Direct labor, and
➢ Manufacturing overhead incurred to produce that product.
To illustrate let us see the presentation of inventories in partial statement of financial positions of a
Manufacturing firm as shown below. The data for cash and account receivable are assumed data.

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 ABC Furniture Factory
Partial Statement of Financial Positions
As at Dec.31, 2009

Current assets:
Inventories:
Direct material 234,900.00
Work in process 263,200.00
Finished good 364,000.00
Total inventories Br. 862,100.00
Account receivables Br. 250,936.00
Allowance for doubtful account 9,156.00
241,780.00
Cash on Hand Br. 25,338.00
Cash at Bank 491,960.00
Total current assets Br.1,621, 178

CHAPTER SUMMARY
Relevant cost is a cost whose magnitude will be affected by decision being made. In decision
making, management should consider only future costs and revenues that will differ under each
alternative. Management is concerned only with those things it can affect. Management cannot
change the cost incurred in the past for purchase of plant and machinery. It can change future cost
by current decisions.
1. Common cost and management terminologies and common understanding of the different cost
and management terminologies enhances the importance of financial reports. Managers need to
know the different cost and management terminologies to best use financial report as such
financial reports contain many cost and management terms. Common cost and management
terminologies also help avoid confusion and misunderstanding.
2. Costs can be classified in different ways. The needs of the managers and accountant govern the
manner in which costs are classified. Costs can be classified as direct and indirect. Direct costs
are those costs that can be traced to the cost object in an economically feasible way. Indirect costs
are costs that are related to the cost object but cannot be traced to the cost object in an
economically feasible way. The classification of costs as direct and indirect is relative. Some costs
are indirect to one cost object but may be direct to another cost object.
3. Costs can also be classified as product and period costs. Product costs are manufacturing costs
that are recorded as asset when incurred and become part of cost of goods sold when the product
is sold. Product costs include direct material, direct labor, and manufacturing overhead.

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4. Manufacturing costs can be classified as prime and conversion costs. Prime cost is the
combination of direct material and direct labor used in production. Prime costs are also called
direct manufacturing costs. Conversion cost is the combination of direct labor and manufacturing
overhead. These costs help to convert materials into finished products. Conversion costs can also
be called processing costs. Period costs are non-manufacturing costs that are recognized as
expenses when they are incurred. Often, they benefit the current period only. Selling and
administrative costs make up period cost.
5. On the basis of the behavior costs exhibit in relation to some cost driver, costs can be classified
as variable and fixed. Variable costs are those costs that respond to a change in the volume of
activity. As the volume of activity increases the total variable costs get upsurge, and as the volume
declines, the total cost falls. Fixed costs are costs that do not respond to a change in the volume
of activity. However, the total fixed cost remains unchanged only over some range, which is called
the relevant range. Some costs have some variable and some fixed component. For instance, the
Ethiopian Telecommunication Corporation charges Birr 50 per month plus an amount based on
the number of calls. The Birr 50 is fixed, and the other portion, which is based on the total cost,
is variable.
6. Differential cost represents the difference in cost between two alternatives. Differential costs are
also called incremental costs. A special case of the differential cost concept is the marginal cost.
Marginal cost is the additional cost of producing one extra unit. Sunk costs are costs that are
already incurred and cannot be reversed by future decision, and hence, irrelevant for future
decision. Opportunity cost represents the income forgone of the next best alternative while
pursuing one course of action over the other. Opportunity cost does not represent immediate cash
outlay or any commitment to pay cash in the future.
7. Product costs represent all manufacturing costs: direct material, direct labor, and indirect
manufacturing costs whereas period costs represent non-manufacturing costs that are incurred in
order to run the operation of the organization. These costs are selling costs and administrative
costs.
8. Cost is said controllable when it can be influenced at the given level of management. If the cost
cannot be influenced at that level of management, then it is said non controllable.
9. Terms costing and cost accounting are interchangeably used; there are differences between the
two. Costing is simply determining costs by using any method like arithmetic process,
memorandum statement etc. Cost accounting on other hand denotes the formal accounting
mechanism by means of which costs are ascertained by recording them in the books of account.

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 10. Opportunity cost is the sacrifice involve in accepting an alternative under consideration. In other
words, it is the income forgone while pursuing one course of action ignoring the next best
alternative. Opportunity cost can also be defined as the cost that measures the benefit that is lost
or sacrificed when the choice of one course of action is being given up.

 Self-Assessment Questions–Chapter Two

Part I – Multiple Choices
Direction: Choose the best answer from the given alternatives.
1. Which one of the following is not an example of variable cost?
A. Direct material C. Direct labor
B. Factory superintendent salary D. Electricity used to run machinery
2. Identify the one that cannot be considered as product cost?
A. Factory insurance C. Materials used
B. Salespeople salaries D. Depreciation – Factory building
3. Which one of the following costs represents an expense?
A. Salary paid to employees
B. Insurance premium paid for a three-year coverage
C. Purchase of Office Equipment
D. Purchase of Direct Material
Answer question 4 and 5 based on the information given below:
TUTU Company’s manufacturing costs in Birr for the year 2019 are as follows:
Direct materials ----------------------------300,000.00
Direct labor -------------------------------- 400,000.00
Factory over head:
Variable---------------------------------80,000.00
Fixed------------------------------------50,000.00
4. Amounts of the Company’s prime cost would be.
A. 700,000.00 C. 780,000.00
B. 530,000.00 D. 830,000.00

5. Amounts of the Company’s conversion cost of the year.

A. 830,000.00 C. 530,000.00
B. 700,000.00 D. 780,000.00
6. Which one of the following statements is/are true?
A. Differential cost is the difference in total cost resulting from selecting one alternative
over the other.

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 B. A sunk cost is a cost that is already incurred and cannot be reversed by future decisions.
C. An Opportunity cost is the benefit foregone by selecting one alternative over the other.
D. All of the above
7. Controllable costs are;
A. Costs that can be controlled by any level of management.
B. Costs that can be influenced at a given level of management.
C. Costs that can be controlled at a given level of management in the long run.
D. All of the above can be answers.
8. Which one of the following is true of a cost object?
A. A cost object is anything for which a separate measurement of cost is desired.
B. It is a factor that casually affects a cost over a given time span.
C. There is a cause and effect relationship between a cost object and total cost of a cost
object.
D. All are correct
9. Identify the true statement concerning a cost driver.
A. Cost driver is a cost object that absorbs cost.
B. Cost of a cost object.
C. An example of a cost driver may be a product, or a department.
D. The answer is not given.
10. Total cost of production incurred in a given month is Br.420, 000 of which 75% is conversion
cost. The cost of direct material at the beginning is Br.30, 000 and cost of direct material ending
is half of the beginning. What is cost of direct material purchased during the month?
A. Br.105,000 C. Br.315,000
B. Br.15,000 D. Br.90,000
11. In a production process, the total prime cost incurred is Br400, 000 and the total conversion
cost is Br320, 000.If the sum of direct material cost and MOH cost is Br.500, 000, the total
cost incurred in the period will be:
A. Br.290, 000 C. Br 580,000
B. Br 110,000 D. Br 610,000

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Part II: Workout Questions
1. Supply the missing data for each company listed below all the amounts are given in Birr.
Company X Y Z W
Sales 300,000 D 390,000 660,000
DM Beginning 27,000 30,000 21,000 J
DM purchased 42,000 45,000 48,000 63,000
DM ending A 24,000 27,000 24,000
Direct labor 75,000 E 51,000 95,500
MOH cost 60,000 54,000 76,500 95,500
WIP beginning 57,000 18,000 G 36,000
WIP ending 48,000 24,000 45,000 30,000
FG beginning 60,000 F 51,000 48,000
FG ending 69,000 33,000 H 54,000
Cost of goods manufactured B 126,000 210,000 K
Cost of goods sold C 132,000 I 300,000
Gross margin 129,000 144,000 162,000 L
2. A fire destroyed XYZ manufacturing Company’s completely on January 25, 2020. Fortunately,
certain accounting records were kept in another building. It revealed the following for the period
from January 1, 2020 to January 25, 2020.
Elements In Ethiopian Birr
Direct material purchased 160, 000
WIP January1,2020 34,000
Direct material January1, 2020 16,000
Finished goods January1, 2020 30,000
MOH cost 40% of conversion cost
Revenue 500,000
Direct labor cost 180,000
Prime cost 294,000
Gross profit based on sales 20%
Cost of goods available for sale 450,000
Required:
(i) Direct material destroyed
(ii) Cost of goods manufactured
(iii)Finished goods destroyed
(iv) WIP destroyed
Answer key: Multiple choice Questions
1. 3. 5. 7. 9. 11
2. 4. 6. 8. 10.

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