UNIT I

COST CONCEPTS AND CLASSIFICATION

COSTS (object, product, project or service) – represent the cash or cash equivalent of resources used in acquiring the
goods, manufacturing a product and performing a function.
- It also includes the cost of distributing the products or services to the ultimate consumers.
- The cash equivalent is used because non-cash assets can be exchanged for the desired goods and services.

1. Product Cost
- Manufacturing costs which include the sum of the inputs or resources used in the production conversion of
raw materials into finished product.
- Otherwise referred to as inventoriable cost as the resources enter the Work in Process account.
- They include costs of materials, labor and overhead.
 The accumulated cost of materials, labor and overhead, called product costs, is later reported in the Income
Statement as expense under the classification costs of goods sold, when the units are sold.
Note: A manufacturing company maintains three inventory accounts.
- Raw materials inventory, work in process and finished goods.

Product costs of completed units – reported in the Finished goods inventory account.
Product of units partially completed – work in process inventory.
Raw materials account – accumulates the cost of direct and indirect materials used in production.

A merchandising company or retailing company ( company engaged in buying goods ready for sale), product
costs include the purchase price of goods bought for resale plus the transportation costs and other direct costs incurred
in bringing the goods to the place of buyer.
Construction company – product costs include the costs of construction materials, labor of carpenters and
overhead incurred in construction like power, light and water, insurance, hospitalization and other health benefits for
workers, maintenance of construction equipment, compensation of foremen, cost of temporary house for the workers
and for construction materials, depreciation of equipment, rentals and other expenses incurred in the construction site.
A service organization – product costs are classified either as direct or indirect costs. Their inventory accounts
are usually for supplies like office supplies for accounting firms or law firms and medical supplies for hospitals and
medical clinics.
The most significant portion of their costs is labor because the workers utilized their own efforts in delivering the
service.
Elements of Product costs: Manufacturing Company
1. Materials: Include the raw materials and other factory supplies used in the manufacturing operation.
They are further classified as:
(a) Direct materials – materials traceable to the product being produced.
e.g. lumber in the manufacture of furniture; galvanized iron and steel – jeepneys and trucks
leather – bags, belts, wallets and shoes; fabrics – shirts, dresses, coats, and other related gents and
ladies apparel. Flour, butter, sugar – bread and other pastries and many more.
(b) Indirect materials - not directly included in or not a significant part of the product.
 Operating, janitorial and factory supplies used in the factory such as nails, screws, washers, glue, sand
paper, lubricating oil, grease, cleaning materials and other materials needed to maintain the working
area and plant equipment in a usable and safe condition.

2. Labor – compensation and benefits paid to those who physically work on the conversion of raw materials into
finished product and are easily traceable to specific process, job or job order.
-represents the compensation and other benefits paid to the workers in the factory.
(a) Direct labor - include basic pay, cost of living allowance, 13th month pay and cash equivalents of non-cash
incentives given on a regular basis.
(b) Indirect labor – wages of personnel other than the direct laborers, which are necessary to the
manufacturing process or service but are not directly related to the actual conversion of raw materials into
finished product.
- Include supervisor’s fee, wages paid to other workers such as janitors, inventory control clerks, guards,
and other personnel in the factory, employee benefits such as employer’s share in SSS, Philhealth and
Pag –ibig, vacation and holiday pay, health insurance of workers, overtime and night premium, costs of
housing and accommodation for stay-in workers.
Direct materials and direct labor – prime costs.
 3. Manufacturing overhead – indirect product cost and includes production costs other than direct materials and
direct labor. They include:
a. Factory supplies - oil and other cleaning materials used in the factory.
b. Wages of supervisors, factory maintenance personnel, raw materials handlers, and security officers
stationed in the factory premises.
c. Depreciation of factory plant and equipment.
d. Insurance and property taxes on factory plant and equipment.
e. Maintenance and repairs on factory plant and equipment.
f. Power, light and water.
g. Telephone and mailing costs.
h. Costs of regulatory compliance such as meeting factory safety requirements
i. and disposal of waste materials.
Conversion costs – direct labor and factory overhead- used to convert raw materials into finished goods.
2. Period Costs – operating expenses that are associated with time periods, rather than with the production of goods
and services.
- charged directly to the expense accounts on the assumption that their benefit is recognized entirely in the
period when the cost is incurred.
- They are non manufacturing costs and non inventoriable costs.
- include selling and marketing costs; distribution costs, administrative costs.
3. Direct and Indirect Costs
Direct costs – obviously and physically traced to a manufacturing process, job or order, business unit, segment or
department. Costs to run a business unit
Indirect Costs – overhead costs – process of production.
4. Common Costs and Joint Costs
Common costs – mutually beneficial costs, costs of facilities or services shared by two or more Departments or
operations.
5. OTHER COSTS CLASSIFICATIONS
a) Opportunity Costs and sunk cost
b) Committed costs and Discretionary Costs
c) Controllable and non-controllable costs
d) Out of the pocket costs and Budgeted Costs
e) Capital expenditures and revenue expenditures
6. Fixed and variable costs
Fixed costs - Fixed costs are constant in total within the relevant range of activity but variable on a per unit basis. As the
activity level increases or decreases, total fixed costs remain constant but unit cost declines or goes up.
Relevant range – limited range of activity within which expenditures can be accurately classified as fixed cost or
variable or the range over which an assumed cost relationship is valid for the normal operations of a firm.
Mixed costs or semi-variable costs – costs that have both fixed and variable component like heat, light and water.
REVIEW EXERCISES: COST CLASSIFICATION
I. Before each account title, indicate FC for Factory cost; SE for Selling Expense; GE for general expense or “X “ for other
classifications:
_________ 1. Indirect materials used ___________16. Bond interest expense
_________ 2. Delivery truck ___________ 17. Controller’s salary
_________ 3. Uncollectible accounts ___________ 18. Depreciation-computer at store
_________ 4. Uniform subsidy-office staff ___________ 19. Depreciation – office equipment
_________ 5. Advertising expense ___________ 20. Direct labor
_________ 6. Wages of factory workers ___________ 21. Fuel for factory equipment
_________7. Office salaries expense ___________ 22. Insurance for salesmen
_________ 8. Factory insurance ___________ 23. Insurance –factory building
_________ 9. Salesmen’s commission ___________ 24. Office supplies
_________ 10. Transportation-in ___________ 25. Packaging supplies used
_________ 11. Heat, light and power ___________ 26. Product samples
_________12. Amortization of Patent ___________ 27. Royalties expense
_________ 13. Supervisors’ salaries ___________ 28. Transportation-out
_________ 14. Real property tax ___________ 29. Transportation-salesmen
_________ 15. Office rent ___________ 30. Utilities – store
 CHAPTER 2: BASIC MANAGERIAL ACCOUNTING CONCEPTS
The Meaning and Uses of Cost
 Determine the cost of products, services, customers, and other items to managers.
 Cost is the amount of cash or cash equivalent sacrificed for goods and/or services that bring a current or future
benefit to the organization.
 As costs are used up in the production of revenues, they are said to expire. Expired costs are called expenses.
 On the income statement, expenses are deducted from revenues to determine income (profit).
 We can look more closely at the relationship between cost and revenue by focusing on the units sold. The revenue
per unit is called price.
Accumulating Costs - The way that costs are measured and recorded.

Assigning Costs - the way that a cost is linked to some cost object.

Cost Objects
 Managerial accounting systems are structured to measure and assign costs.
 A cost object is any item such as a product, customer, department, project, geographic region or plant, for which
costs are measured and assigned.
Assigning Costs to Cost Objects
 Costs can be assigned to cost objects in a number of ways.
 The choice of a method depends on a number of factors, such as the need for accuracy.
 The objective is to measure and assign costs as well as possible, given management objectives
For Which Business Activities Do We Need an Estimate of Cost? (slide 10)

Direct Costs - are costs that can be easily and accurately traced to a cost object.
 When a cost is easy to trace, we mean that the relationship between the cost and the object can be physically
observed, is easy to track, and results in more accurate cost assignments.

Indirect Costs - are costs that cannot be easily and accurately traced to a cost object.
 Allocation means that an indirect cost is assigned to a cost object by using a reasonable and convenient method.
 Allocating indirect costs is based on convenience.

Object Costing (Slide 13)

 Direct and indirect costs occur in service businesses as well.
o Some businesses refer to indirect costs as overhead costs or support costs.

Other Categories of Cost

 Costs can be direct or indirect, and are analyzed by their behavior patterns, or the way in which a cost changes when
the level of the output changes.
 Variable cost: A variable cost is one that increases in total as output increases and decreases in total as output
decreases.
 Fixed cost: A fixed cost is a cost that does not increase in total as output increases and does not decrease in total as
output decreases.
 Opportunity cost: An opportunity cost is the benefit given up or sacrificed when one alternative is chosen over
another.

Product Costs
 Output represents one of the most important cost objects.
 There are two types of output: products and services.
 Products are goods produced by converting raw materials through the use of labor and indirect manufacturing
resources, such as the manufacturing plant, land, and machinery.
o Televisions, hamburgers, automobiles, computers, clothes, and furniture are examples of products.

Service Costs
  Services are tasks or activities performed for a customer or an activity performed using an organization’s
products or facilities.
 Insurance coverage, medical care, dental care, funeral care, and accounting are examples of service activities.
 Car rental, video rental, and skiing are examples of services where the customer uses an organization’s products
or facilities.
 Services differ from products in many ways:
o Service are intangible
o Services are perishable
o Services require direct contact between providers and buyers

Providing Cost Information

 Managerial accountants must decide:
o what types of managerial accounting information to provide to managers,
o how to measure such information, and when and to whom to communicate the information.
 Managers rely on managerial accounting information that is prepared and provides the best analysis for the
decision at hand.
 There is one major exception.
 Managerial accountants must follow specific external reporting rules (i.e., generally accepted accounting
principles)
o When providing outside parties with cost information about the amount of ending inventory on the
balance sheet and the cost of goods sold on the income statement.
o To calculate these two amounts, managerial accountants must subdivide costs into functional
categories: production and period (i.e., nonproduction).

Determining Product Cost (Slide 22)

 Product manufacturing) costs are costs, both direct and indirect, of producing a product in a manufacturing firm
or of acquiring a product in a merchandising firm and preparing it for sale.
o Only costs in the production section of the value chain are included in product costs.
 Product costs are inventoried.
 Product costs are first added to an inventory account and remain in inventory until sold, at which time they are
transferred to cost of goods.
 Product costs are classified as direct materials, direct labor, and manufacturing overhead.

Direct Materials
 materials that are a part of the final product and can be directly traced to the goods being produced.
 Materials cost can be directly charged to products because physical observation can be used to measure the
quantity used by each product.
 Materials that become part of a product usually are classified as direct materials.

Direct Labor
 the labor that can be directly traced to the goods being produced.
o Physical observation can be used to measure the amount of labor used to produce a product.
o Those employees who convert direct materials into a product are classified as direct labor.
 A company can also have indirect labor costs.
o Indirect labor is included in overhead and, therefore, is an indirect cost rather than a direct cost.

Manufacturing Overhead
 All product costs other than direct materials and direct labor are considered manufacturing overhead.
 Manufacturing overhead also is known as factory burden or indirect manufacturing costs
 Costs are included as manufacturing overhead if they cannot be traced to the cost object of interest (e.g., unit of
product).
 Costs are included as manufacturing overhead if they cannot be traced to the cost object of interest (e.g., unit of
product).
 Manufacturing overhead cost category includes a variety of items.
o Examples: depreciation on plant buildings and equipment, janitorial and maintenance labor, plant
supervision, materials handling, power for plant utilities, and plant property taxes.

Calculating Total Product Cost

 The total product cost equals the sum of direct materials, direct labor, and manufacturing overhead:
Total product post = Direct materials cost + Direct labor cost + Manufacturing overhead cost
 The unit product cost equals total product cost divided by the number of units produced:
Per-unit Cost = Total Product Cost ÷ Number of Units Produced

Calculating Product Cost in Total and Per Unit (Slide 28)

Prime and conversion Costs

  Product costs of direct materials, direct labor, and manufacturing overhead can be grouped into prime cost and
conversion cost
o Prime cost is the sum of direct materials cost and direct labor cost.
Prime cost = Direct materials + Direct labor
o Conversion cost is the sum of direct labor cost and manufacturing overhead cost.
Conversion cost = Direct labor + Manufacturing Overhead

Calculating Prime Cost and Conversion Cost in Total Per Unit (Slide 31)
Information: Refer to the information in Cornerstone 201 (p.35) for BlueDenim Company.
Required:
1. Calculate the totoal prime cost for last week
2. Calculate the per-unit prime cost
3. Calculate the total conversion cost for last week
4. Calculate the per-unit conversion cost

Period Costs (slide 35)

 Costs of production are assets that are carried in inventories until the goods are sold.
 Other costs, such as period costs, are not carried in inventory.
o Period costs are all costs that are not product costs (i.e., all areas of the value chain except for production).
 Examples: Office supplies, research and development activities, the CEO’s salary, and advertising.
 The level of period costs can be significant and controlling them may bring greater cost savings than the same effort
exercised in controlling production costs.
 Period costs typically are expensed in the period in which they are incurred.
 If a period cost is expected to provide an economic benefit (i.e., revenues) beyond the next year, then it is recorded
as an asset (i.e., capitalized) and allocated to expense through depreciation throughout its useful life.

Selling Costs (Slide 36)

 Those costs necessary to market, distribute, and service a product or service are selling costs

Administrative Costs
 Administrative costs include research, development, and general administration of the organization and cannot
be assigned to either selling or production.
 General administration ensures that the various activities of the organization are integrated so that the overall
mission of the firm is realized.
 Examples: executive salaries, legal fees, printing the annual report, and general accounting.
 Research and development costs are the costs associated with designing and developing new products and
must be expensed in the period incurred.

Direct and Indirect Period Costs (slide 40)

 Distinguishing between direct period costs and indirect period costs.
 Indirect labor is included in overhead.
 Service companies: distinguishing between direct period costs and indirect period costs.
 These costs do not affect the calculation on inventories or COGS for service companies.
 Correct classification affects decisions, planning and control activities for managers.

Preparing Income Statements: Cost of Goods Manufactured

 The cost of goods manufactured represents the total product cost of goods completed during the current period
and transferred to finished goods inventory.
 The cost of direct materials used in production can be derived using the following formula:
Beginning Inv of materials + Purchases – Direct Materials used in Production = Ending Inv. Of Materials
 The direct materials is then used to calculate the cost of goods manufactured as follows:
+ Direct materials
+ Direct labor
+ Manufacturing overhead costs
+ Beginning WIP inventory
- Ending WIP inventory
= Cost of goods manufactured

Calculating Direct Materials used in Production (Silde 43)

Work in Process
 Once the direct materials are calculated, the direct labor and manufacturing overhead for the period are added
to get the total manufacturing cost for the period.
 The second type of inventory work in process (WIP) is the cost of the partially completed goods that are still on
the factory floor at the end of a time period.
 WIP units have been started, but not finished; they have some value, but not as much as they will when they
are completed; and there are beginning and ending inventories of WIP.
 We must adjust the total manufacturing cost for the time period for the inventories of WIP.
 When that is done, we will have the total cost of the goods that were completed and transferred from work-in-
process inventory to finished goods inventory during the time period.

Calculating Cost of Goods Manufactured (Slide 47)

Cost of Goods Sold

 To meet external reporting requirements, costs must be classified into three categories:
o Production
o Selling
o Administration
 represents the cost of goods that were sold during the period and then transferred from finished goods
inventory on the balance sheet to cost of goods sold on the income statement (i.e., as an inventory expense).
Cost of goods sold is calculated as:
+ Beginning finished goods inventory
+ Cost of goods manufactured
-Ending finished goods inventory
= Cost of goods sold

Calculating COGS(50)

Relationship between Flow of Costs, Inventories, and Cost of Goods Sold (52)

Income Statement: Manufacturing Firm

 It is important that all sales revenue and expenses attached to a time period appear on the income statement.
 In the following Cornerstone example 2.6, notice that the heading of the financial statement tells us what type
of statement it is Income Statement; for what firm BlueDenim Company; and for what period of time For the
Month of May.
 Also note that in the income statement, expenses are separated into three categories: production (cost of goods
sold), selling, and administrative.
 Sales revenue is calculated as: Sales Revenue = Price x Units Sold

Preparing Income Statement for a Manufacturing Firm (55)

Income Statement: Manufacturing Firm

 Gross margin is the difference between sales revenue and cost of goods sold:
Sales Revenue - Cost of Goods Sold = Gross Margin
 It shows how much the firm is making over and above the cost of the units sold.
 Gross margin does not equal operating income or profit as it is computed without subtracting selling and
administrative expenses.
 If gross margin is positive, the firm is charging prices that cover the product cost.

Gross Margin Percentage

 A company can compare gross margin percentage with the average for its industry to see if its experience is
within the ballpark range for other firms in the industry.
  Gross margin percentage varies significantly by industry.
 Gross margin percentage is calculated as:
Gross Margin Percentage = Gross Margin ÷ Sales Revenue

Calculating the Percentage of Sales Revenue for Each Line: Income Statement (59)

Operating Income
 As you saw in Cornerstone 2.7, selling and administrative expenses for the period are subtracted from gross margin
to arrive at operating income.
Operating income = Gross margin – Selling and administrative expenses
 Operating income is the key figure from the income statement; it is profit, and shows how much the owners are
actually earning from the company.

Income Statement: Service Firm

 In a service organization, there is no product to purchase, like in a merchandising or manufacturing operation.
 There are no beginnings or ending inventories and no cost of goods sold and gross margin on the income
statement.
 The cost of providing services appears along with the other operating expenses of the company.

Preparing and Income Statement for a Service Organization (62)