Chapter 2: Costs – Concepts and Classifications

Summary notes

Classification of Costs

As to variability Relation to
Relation to a
product manufacturing
departments

Manufacturing Non-manufacturing  Variable Costs

 Direct departmental charges
Costs/Product costs Costs/Period costs  Fixed costs
 Indirect departmental charges
 Mixed Costs

 Direct  Marketing or
Materials selling expense
 Direct Labor  General or Nature as a Relation to an For planning, control,
 Factory administrative common or joint accounting period and analytical
Overhead expense processes

 Common costs  Capital

expenditures  Standard costs
 Joint costs
 Revenue  Opportunity costs
expenditures  Differential cost
 Relevant costs
 Out-of-pocket cost
 Sunk costs
 Controllable cost
 I. COST CLASSIFIED AS TO RELATION TO A PRODUCT
A. Manufacturing Costs/Product Costs/Inventoriable Costs
Direct Materials

- They are the basic ingredients that are transformed into finished products through the use of labor
and factory overhead in the production process.
Direct Labor

- They represent the amount of paid as wages to those working directly on the product. It includes
all labor costs for specific work performed on products that can be conveniently and
economically traced to end products.
Factory Overhead

- These are costs varied collection of production-related costs that cannot be practically or
conveniently traced directly to end products.
- Also called manufacturing overhead, factory burden, and indirect manufacturing costs.
- Examples are indirect material and indirect labor, indirect factory costs.

B. Non-manufacturing costs/Period Costs

Marketing or selling expenses

- Include all costs necessary to secure customer orders and get the finished product or service into
the hands of the customer.
- Often referred to as order-getting and order-filling costs.

Administrative or General expenses

- Include all executive, organizational, and clerical expenses that cannot logically be included
under either production or marketing.

II. COST CLASSIFIED AS TO VARIABILITY

Fixed Cost

- Items of cost which remain constant in total, irrespective of the volume of production. Cost per
unit decreases as volume increases and increases as volume decreases.
- Classified into two categories
o Committed fixed costs – costs that represent relatively long-term commitments on the
part of management as a result of a past decision. (Ex. Depreciation on equipment)
o 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. (Ex. Advertising,
research and development and costs of training of employees)
Variable cost

- These are the 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
Mixed cost

- Items of costs with fixed and variable components.

- Two types of mixed costs, semi-variable costs and step costs
o Semi-variable cost – the fixed portion of a semi-variable cost usually represents a
minimum fee for making a particular item or service available.
o Step costs – the fixed part of step costs changes abruptly at various activity levels
because these costs are acquired in indivisible portion
- There are different of separating mixed costs into fixed and variable components:
o High-low Point Method
o Method of Least Square

III. COSTS CLASSIFIED AS TO RELATION TO MANUAFCTURING DEPARTMENTS

Direct departmental charges

- Costs that are immediately charged to the particular manufacturing department that incurred the
costs since the costs can be conveniently identified or associated with the department that
benefited from said costs.
Indirect departmental charges

- Costs that are originally charged to some other manufacturing department or account but are later
allocated r transferred to another department that indirectly benefited from said costs.

IV. COSTS CLASSIFIED TO THEIR NATURE AS COMMON OR JOINT

Common Cost

- Costs of facilities or services employed in two or more accounting periods, operations,

commodities, or services. Just like indirect costs, these are subject to allocation.
Joint Cost

- Costs of materials, labor, and overhead incurred in the manufacture of two or more products at
the same time. They are indivisible and they are not specifically identifiable with any of the
products being simultaneously needed. These costs are also subject to allocation.

V. COSTS CLASSFIED AS TO RELATION TO AN ACCOUNTING PERIOD

Capital Expenditure
 - Expenditure intended to benefit more than one accounting periods and is recorded as an asset.
The allocation of the cost to the different periods is – depreciation for fixed tangible assets,
amortization of intangible assets and depletion for wasting assets.
Revenue expenditure

- Expenditure that will benefit current period only and is recorded as an expense.

VI. COSTS FOR PLANNING, CONTROL, AND ANALYTICAL PROCESS

Standard costs

- It’s a budget for the production of one unit of product or service. It is a cost chosen by the
managerial accountant to serve as the benchmark in the budgetary control system.
Opportunity Cost

- The benefit given up when one alternative is chosen over another. They are usually not recorded
in the accounting system but they should be considered when evaluating alternatives for decision-
making.
Differential costs

- Cost that is present under one alternative but is absent in whole or in part under another
alternative.
o Incremental cost – an increase in cost from one alternative to another.
o Decremental cost – a decrease in cost from one alternative to another.
o Marginal Revenue – revenue that can be obtained from selling one more unit of product.
o Marginal cost – cost involved in producing one more unit of product.

Relevant cost

- A future cost that changes across the alternatives.

Out-of-pocket cost

- Cost that requires the payment of money (or other assets) as result of their incurrence.

Sunk Cost

- Cost which are already incurred and therefore irrelevant in decision making process

Controllable and Non-controllable costs

- A cost is considered to be a controllable cost at a particular level of management if that level has
power to authorize the cost.
COST FLOW-MANUFACTURING FIRMS
Cost Occurrence
Expense Category
Material
Inventory
WP FG
When unused Inventory Inventory

Direct Unfinished Unsold

Materials

Direct Work in Finished Cost of goods sold

Labor When used Process Goods

Factory
Overhead

Selling and Operating Expenses

Administrative

FORMULAS
1. Prime Costs = Direct Materials + Direct labor
2. Conversion costs = Direct labor + Factory overhead
3. Total manufacturing costs = Direct materials + Direct labor + Factory Overhead
4. Total variable costs = Variable cost per unit x total output
5. Total cost = Total variable cost + total fixed cost
6. Variable rate = Highest point cost – Lowest point cost
Highest output – Lowest output
7. Fixed cost = total cost at highest – (variable rate x output at highest point)
8. Fixed cost = total cost at lowest – (variable rate x output at lowest point