CHAPTER 2:

Costs – Concepts and

classification
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The first step in managing
cost is to understand it
What is cost?

Cost is the cash or cash equivalent value sacrificed for goods and
services that are expected to bring a current or future benefit to the
organization.
COST

Unexpired Cost Expired Cost

Asset Expense/Loss
Cost Classifications

A. Costs classified as to relations to product

B. Costs classified as to variability
C. Costs classified as to relation to manufacturing department
D. Costs classified as to their nature as common or joint
E. Costs classified as to relation to an accounting period
F. Costs for planning, control and analytical procedure
Cost classified as to relation to a
product
Manufacturing Costs /
Product Costs / Non-manufacturing
Inventoriable Costs Costs / Period Costs

 Direct Materials  Marketing or Selling Expenses

 Direct Labor  Administrative Expenses
 Factory Overhead
Manufacturing Costs
 A.k.a Product costs because these are the costs needed in creating a
product
 A.k.a Inventoriable costs because these costs are the component value
of the inventories

Direct Materials (DM)

 are materials that become part of the finished product and can be
conveniently and economically traced to specific product
Example: Wood of the table, fabric of the clothes, potato for the fries,
metals for vehicles
Direct Labor (DL)
 These include all labor costs for specific work performed on products
that can be conveniently and economically traced to end products
Example: Carpenter, tailor, cook, mechanic
Manufacturing Costs
Factory Overhead (FOH)
 it’s a catchall for other manufacturing costs that cannot be classified as
DM and DL. (Residual definition)
 These are production related costs that cannot be practically or
conveniently traced directly to end product
 Also called as Manufacturing Overhead (MOH), Factory Burden, Indirect
Manufacturing Costs

Indirect Materials  these are minor materials and other production

supplies that cannot be conveniently or economically traced to specific
products
Examples: Nails, needle, salt, bolts and screws
Manufacturing Costs
Indirect Labor labor costs for production related activities that
cannot be conveniently and economically traced to end product
Examples: Factory Utilities Personnel, Factory Supervisors, Factory
Managers

Other  other indirect expenses that can not be identified as indirect

materials and indirect labor
Examples: Factory repairs and maintenance, taxes, insurance,
depreciation, rent and utilities
Manufacturing Costs

Manufacturing
Cost

Direct Materials Direct Labor Factory Overhead

Conversion
Prime Cost
Cost
Non-Manufacturing Costs
 Non-manufacturing costs are also called period costs

Marketing/Selling Expense
 Include all necessary to secure customer orders and get the finished
product/service into the hands of the customer
Examples: Advertising, shipping cost, sales commission & salaries, and
warehousing

Administrative/General Expense
 Include all executive, organizational, and clerical expenses that cannot logically
be included under production or marketing.
Examples: Executives’ salaries, accounting, and legal

Collective term for Marketing and Administrative expenses is Operating Expenses

(OpEx)
Expense account classification may
vary based on the nature of the account
Account FOH Selling Administrative
Supervisor’s Factory Store Supervisor Admin
Salary Supervisor Department
Supervisor
Depreciation Factory Store Admin
Machineries Machineries Department
Machineries
Building Rental Factory Rental Store Rental General office
rental
Electricity Factory Store Electricity General office
Electricity electricity
Exercise: Problem 2
Classify the following as either manufacturing (M), selling (S), or
administrative (S)
1. Metal for the manufacture of golf clubs. M-DM
2. Wages of drivers delivering goods to customers. S
3. Rent of factory building. M-FOH

4. Freight-in of materials purchased. M-DM

5. President’s salary. A
6. Cost of machine breakdown. M-FOH
7. Power to operate factory equipment. M-FOH
8. Advertising. S
9. Commission paid to sales personnel. S
10. Travel expenses of salesmen. S
 Exercise: Problem 3
Product Cost Period Cost
Cost DM DL FOH Selling Admin
Direct Materials P220,000
Factory Rent P50,000
Direct Labor
P180,000
Factory Utilities
8,500
Supervisor’s
Salary 60,000
Depreciation – FE 20,000
Sales Commission P57,000
Advertising 47,000
Depreciation – OE P10,000
Salary - President 250,000
Total P220,000 P180,000 P138,500 P104,000 P260,000
P538,500 P364,000
Exercise: Problem 3

Cost per unit = Total Manufacturing Cost

Total No. of Units
Cost per unit = P538,000
40,000 units
Cost per unit = P13.4625/unit
Costs classified as to Variability
Variability means the way a cost changes in relation to changes in the
activity level of the organization. This is sometimes referred to Cost
Behavior

Activity refers to a measure of the organization’s output of products or

services.

Relevant Range refers to a specific activity level that is bounded by

minimum and maximum amount. Within the said range, cost behavior is
normal/valid
Costs classified as to Variability
Fixed Costs (FC)
 These are costs which remain constant in total irrespective of the
volume of the production.
 Cost per unit decreases as volume increases and increases as volume
decreases

Two Categories of Fixed Costs

Committed Fixed Costs  costs that represent relatively long-term
commitments on the part of management as a result of a past decision
Examples: Depreciation, Rent
Managed Fixed Costs  costs that are incurred on a short-term basis
and can be more easily modified in response to changes in management
objectives
Examples: Advertising, Salaries
 Costs classified as to Variability
Sample graph of Fixed Cost

Total Fixed Cost

1,500

10 30 Activity
20
 Costs classified as to Variability
Variable Costs (VC)
 Items of cost which vary directly in total in relation to volume of
production
 Cost per unit remains constant as volume changes within a relevant
range.
Total Variable
Cost Examples: Direct Materials, Direct Labor, Sales Commission

3,000
Sample Graph
of Variable Cost

2,000

1,000
Activity

10 20 30
Costs classified as to Variability
Total Unit

Variable Varies Directly Constant

Fixed Constant Varies Inversely

Costs classified as to Variability
Mixed Costs
 Items of cost with fixed and variable components
 These vary with the level of production though not in direct relation to it

Two types of Mixed Costs

Semi-Variable  the fixed portion of it usually represents a minimum fee
for making a particular item or service available. The variable portion is the
cost charged for actually using the service.
Examples: Post-paid plan, Parking Fee, Contingent Rent
Step Costs  the fixed part changes abruptly at various level of activity. It
is a similar to fixed cost within a very small relevant range
Examples: Supervisor’s Salary, Rent of Machine based on output
 WALANG FOREVER!

Mixed Cost

Fixed Cost Variable Cost

Mixed Costs shall be separated into fixed and variable

components
Exercise: Problem 4
Classify each of the following costs of Bug Company in two ways: (a) as variable (V) or fixed
(F) costs; (b) as inventoriable (I) or period (P) cost
(a) (b)
V
1. Wood used in book cases
IV
2. Machine depreciation based on MHrs IF
3. Fire insurance on factory equipment
IV
4. Wiring used in radios
IV
5. Indirect materials IV
6. Sales commissions
P
V
7. Bottles used to package liquid
IV
8. Gasoline for delivery truck
P
9. Straight line depreciation of trucks used for F
delivery of sales to customers P
V
10.Machine operators’ hourly wages
I
Exercise: Problem 5

Number of Mufflers Replacements

400 500 800
Total Costs
Fixed Costs P50,000 P50,000 P50,000
Variable Costs 48,000 60,000 96,000
Total Costs 98,000 110,000 146,000
Cost per Muffler Replacement
Fixed Costs P125 P100 P62.50
Variable Costs 120 120 120
Total cost per replacement P245 P220 182.50
Costs classified as to Variability
Different Separation Methods
1. Scatter Graph
  is a graphical technique of separating fixed and variable components of mixed
cost by plotting activity level along x-axis and corresponding total cost (mixed cost)
along y-axis
 A regression line is then drawn on the graph by visual inspection
 The point where the line intercepts y-axis is the estimated fixed cost and the slope
of the line is the average variable cost per unit

2. High-Low Method
 used the highest and lowest points in the population. Except outliers
 get the difference between the highest and lowest points as to amounts and level
of activities
 Compute for variable cost per unit by dividing the difference as to amounts by the
difference as to level of activities
 Compute the total fixed cost using the cost formula
Costs classified as to Variability
Formulas
Variable Cost per unit = Highest Cost – Lowest Cost
Highest Activity – Lowest Activity

Y = a + bX (cost formula)
Wherein:
Y = total cost
a = total fixed costs
b = variable cost per unit
X = level of activities

Note: Cost formula must be valid to all levels of activities

Costs classified as to Variability
3. Method of Least Square
 most accurate method in separating fixed and variable components
of mixed costs
 use all data in the population
 compute first for the variable cost per unit by way of elimination
 compute the total fixed cost by way of substitution

Formulas
Equation 1: Y = a + bX
Equation 2: ∑Y = na + b∑X
Equation 3: ∑XY = ∑Xa + b∑ X2
Costs classified as to Variability
Least Square Method derived formula

b = n∑XY – (∑X)(∑Y)
n∑X2 – (∑X)2

a = ∑Y - b∑X
n
Exercise: Problem 12
Requirement 1
b= HC – LC = 5,475 – 3,975 = 1,500 P23.0769/un
=
HA – LA 210 – 145 65 it

Highest Point Lowest Point

Y = a + bX Y = a + bX
5,475 = a + (210)(23.0769) 3,975 = a + (145)(23.0769)
5,475 = a + 4,846.15 3,975 = a + 3,346.15
a = 5,475 – 4,846.15 a = 3,975 – 3,346.15
a = 628.85 a = 628.85
Requirement 2
Y = a + bX
Y= 628.85 + (300)(23.0769)
Y= 628.85 + 6,923.07
Y= 7,551.92
 Exercise: Problem 12
Machine Overhead
Requirement 3 Hours (X) Costs (Y)
XY X2
Equation2: ∑Y = na + b∑X
175
4,500
787,500 30,625 Equation 3: ∑XY = ∑Xa + b∑ X2
170 718,250 28,900
4,225

160 691,360 25,600 55,381 = 12a + 2,085b

4,321

190 997,500 36,100

9,714,785 = 2,085a + 366,375b
5,250

175 840,000 30,625

4,800
[55,381 = 12a + 2,085b] [2,085]
200 1,020,000 40,000
5,100 [9,714,785 = 2,085a + 366,375b]
160
4,450
712,000 25,600 [12]
150 630,000 22,500
4,200

210 1,149,750 44,100

115,469,385 = 25,020a +
5,475
4,347,225b
180 856,800 32,400
4,760 116,577,420 = 25,020a +
170
4,325
735,250 28,900 4,396,500b
145 576,375 21,025
3,975
-1,108,035 = -49,275b
2,085 55,381 9,714,785 366,375
b = 22.4868
Exercise: Problem 12

55,381 = 12a + 2,085b 9,714,785 = 2,085a + 366,375b

55,381 = 12a + (2,085)(22.4868) 9,714,785 = 2,085a + (366,375)
(22.4868)
55,381 = 12a + 46,884.98 9,714,785 = 2,085a + 8,238,601.35
12a = 55,381 - 46,884.98 2,085a = 9,714,785 - 8,238,601.35
12a = 8,496.02 2,085a = 1,476,183.65
a = 8,496.02/12 a = 1,476,183.65/2,085
a = 708.00 a = 708.00
Exercise: Problem 12
Alternative procedure

b = n∑XY – (∑X)(∑Y) a = ∑Y - b∑X

n∑X2 – (∑X)2 n

b = (12)(9,714,785)– (2,085) a = 55,381 – (22.4868)(2,085)

(55,381)
(12)(366,375)– (2,085)2 12

b = 116,577,420 – 115,469,385 a = 55,381 – 46,884.98

4,396,500 - 4,347,225 12

b = 1,108,035 /49,275 a = 8,496.02/12

b = 1,108,035 /49,275 a = 708.00
b = 22.4868
Common Cost vs. Joint Cost
Common cost
 Cost of facilities or services employed in two or more accounting periods,
operations, commodities or services
 These costs are subject to allocation
Example: Building Depreciation, Rental

Joint Cost
 Costs of materials, labor, and overhead in the manufacturing of two or
more products at the same time
 These costs are indivisible and they are not specifically identifiable
 These costs are also subject to allocation
Examples: Manufacturing of bi-products/joint products
Capital Expenditure VS Revenue Expenditure
Capital Expenditure
 Expenditure intended to benefit more than one accounting periods and
is recorded as an asset (Unexpired Cost)
Examples: Fixed Assets, Intangible Assets

Revenue Expenditure
 Expenditure that will benefit current period only and is recorded as on
expense (expired cost)
Examples: COGS, Selling Expenses, Administrative Expenses
Direct VS Indirect Departmental Charges
Direct Departmental Charges
 Costs that are immediately charged to the particular department/s that
incurred the costs since the costs can be conveniently identified or
associated with the department/s that benefited from the said costs
Examples: Salary of Accounting Manager

Indirect Departmental Charges

 Costs that are originally charged to some other department/s but later
allocated or transferred to another department/s that indirectly
benefited from the said cost
Examples: Salary of President, Building Rental
Controllable Cost VS Non-controllable Cost

A cost is said to be controllable at a particular level of management if that

level has power to authorize the cost, otherwise, the cost is non-
controllable.
Example: Salary of HR staff and salary of President

In some situations, there is a timing factor as to cost controllability. A cost

that are controllable over the long run but not over the short run
Example: Advertising cost, rental contract, service agreement
Costs for planning, control and analytical processes
Standard Costs
 Predetermined costs for DM, CL and FOH. It is a budgeted cost for the production of one unit of
product or service. This cost serves as benchmark in the budgetary control system
Opportunity Cost
 Benefit foregone when choosing one alternative over another. This cost is not usually recorded in
any accounting books/reports.
Example: Company Shut-down, Grab over normal transportation
Differential Cost
 Cost that is present under one alternative but is absent in whole or in part under another
alternative
 Incremental cost & Decremental cost
Relevant Cost
 A future cost that change across alternative (future & differential)
Out-of-Pocket Cost
 Cost that requires the payment of money as a result of their incurrence
Example: Reimbursement for transportation and meal allowance
Sunk Cost
 Cost for which an outlay has already been made and it cannot be changed by present or future
decision. These costs are irrelevant costs
THANK YOU!
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