Mindanao State University

College of Business Administration and Accountancy

COST CONCEPTS AND CLASSIFICATIONS

MEANING OF COST AND ITS USES a. Direct manufacturing cost – those that
One objective of management accounting is to determine are easily traceable to specific units of
the cost of products, services, customers and any other production such as direct labor and
items of interest to managers. In understanding costs and as direct materials.
to how it can be used by management, the following terms b. Indirect manufacturing cost – those
and concepts are relevant: collection of product costs cannot be
A. Cost – foregoing or potential expenditures (any practically or conveniently traced to
form of current or future cash outlay) measured in end products such as factory
monetary terms to achieve a specific objective; a overhead.
sacrifice required to attain a given objective.  Non-manufacturing costs – the operating
B. Expenses – measured outflow of goods and expenses of the business or those costs not
services that are matched against revenues to incurred in transforming materials to finished
determine income; an expired cost. goods.
C. Loss – a form of expired cost that is not beneficial a. Marketing expenses – distribution
to revenue producing activities of the enterprise; expense or selling expensesor those
no benefits were derived from this particular cost. that covers the expenses of making
D. Cost object – anything for which cost is computed sales and delivery of products sold.
such as a customer, product, a product line or a b. Administrative expenses – expenses
segment of an organization. incurred in the direction, control and
E. Cost driver – any variable such as a level of activity administration of the organization.
or volume that usually affects costs over a period of c. Research and development – incurred
time. in designing and bringing new products
to the market.
F. Activity – an event, action, transaction, task or unit
d. After-sales costs – costs incurred in
of work with a specified purpose. Activities can be
dealing with customers after sales such
classified into:
as warranty and repair costs.
 Value adding activities – activities that are
necessary or non-eliminable to produce the B. Classification as to applicability to accounting
products such as assembling the different periods:
component parts of the product.  Capital expenditures – outlays classified first as
 Non-value adding activities – activities that an asset before being recognized as expense.
do not make the product or service more  Revenue expenditures – outlays classified
valuable to customer such as moving the directly as an expense.
materials and equipment parts from/to  Product cost – cost included in the calculation
stockroom or a workstation. of inventory costs; also known as inventoriable
G. Value chain – a set of activities that a firm costs.
operating in a specific industry performs in order to  Period cost – costs charged against current
deliver a valuable product or service for the period operations and treated as expense
organization’s customers. immediately.
 Research and development – experimenting
to reduce costs or improve quality. C. Classification according to managerial influence:
 Design – developing alternative product,  Controllable cost – cost that is subject to
service or process designs. influence by a particular manager within the
 Supply – managing raw materials received time period under consideration.
from vendors to reduce costs and improve  Non-controllable cost – cost which a
quality. manager does not have a significant
 Production – acquiring and assembling influence over.
resources to produce a product or render a D. Classification for planning, control and decision
service. making purposes:
 Marketing – promoting a product or service to
 Standard cost – costs pegged at a
current and prospective customers.
predetermined rate usually expressed on a
 Distribution – delivering a product or service to
per unit basis; in total, it is the cost that “should
a customer.
have been incurred” for actual production.
 Customer service – supporting customers after
the sale of a product or service.  Budgeted cost – future costs usually expressed
in totals; in total, the cost represents the
H. Cost pool – a grouping of individual cost items; an
“should be incurred” for budgeted
account in which a variety of similar costs are
production.
accumulated such as work in process and factory
 Relevant costs – future costs that will differ
overhead control accounts.
under alternative courses of actions.
CLASSIFICATIONS OF COSTS  Irrelevant cost – costs that will not affect the
Costs can be classified in a number of ways depending on decision making process, thus, is ignored in
the purpose of the classification. Such classifications of the analysis.
costs are not mutually exclusive.  Differential cost – difference in cost between
A. Classification as to function: any two alternative courses of action.
 Manufacturing costs – production costs of a. Incremental costs – increase in cost
factory related activities or those that are from one alternative to the other.
incurred to transform materials to finished b. Decremental costs – decrease in cost
goods. from one alternative to the other.
  Marginal cost – additional costs expressed on management is “stuck” with over an
a per unit basis. extended period of time such as
 Postponable costs – costs that may be depreciation and long-term lease
deferred or shifted to a future date or period contract.
of time without adversely affecting current b. Programmed or discretionary or
operations. managed costs – cost for which the
 Avoidable cost – cost that can be eliminated size or the time of incurrence is a
in whole or in part when one alternative is matter of choice of management
chosen over another in a decision making such as advertising costs and research
case. and development costs.
 Unavoidable cost – costs that remain  Mixed cost – this cost has both a variable and
regardless of what decision or alternative is a fixed component.
chosen.
 Out of pocket cost – cost that require current
or future cash outlay.
 Opportunity cost – cost of benefits foregone
as the result of the acceptance of an
alternative. It is measured as the benefits that
would result from the next best alternative use
of the same resources that were rejected in
favor of the one accepted.  Step cost – when activity changes, a step cost
 Imputed cost – hypothetical cost representing shifts upward or downward by a certain
the usage value of a particular resource. interval or step.
 Sunk or past or historical cost – cost which are
already incurred and therefore irrelevant in
decision making process.
E. Classification in relation to a cost object:
 Direct cost – costs that are related to a
particular cost object and can be
economically and effectively be traced to
that cost object. a. Step variable cost – a step cost that
 Indirect costs – cost that are related to a cost have smaller steps.
object but cannot practically, economically b. Step fixed cost – a step cost that have
and effectively be traced to such cost object. larger steps.
Factors affecting the direct-indirect cost  Non-linear cost – total cost increases but per
classification follow: unit decreases as activity increases.
a. Materiality of the cost in question.
b. Design of operations.
c. Availability of an information-gathering
technology.
d. Choice of cost object.
 Common cost – cost that benefit more than
one activity or department.
 Joint cost – apply to situations where multiple
outputs are derived from one source.
To analyze curvilinear costs is to determine the
F. Classification as to the tendency to vary with relevant range represented by the straight-
volume or activity: line in the graph.
 Variable cost – within the relevant range and
time period under consideration, the total COST BEHAVIOR ASSUMPTIONS
amount varies directly to the change in In management accounting, cost behavior refers to the
activity level or cost driver and the per unit way in which costs are affected by fluctuations in the cost
amount is constant. driver, i.e. level of activity. An understanding of cost
behavior patterns is essential for many management tasks,
particularly in the areas of planning, decision-making and
control. It would be impossible for managers to forecast
and control costs without at least a basic knowledge of the
way in which costs behave in relation to the cost driver.
Economists correctly point out that many costs that
accountants classify as variable costs actually behave in a
curvilinear fashion. Nonetheless, within a narrow band of
 Fixed cost – within the relevant range and activity, a curvilinear cost can be satisfactorily
time period under consideration, the total approximated by a straight line. In determining cost
amount remains unchanged and the per unit behavior, certain assumptions are assumed by the
amount varies inversely or indirectly with the accountant:
change in the cost driver. A. Relevant range – the band or level of activity where
the cost concepts and the relationship of variable
and fixed costs are considered valid. In the relevant
range, the following holds true:
Total Amount Per Cost Driver
Variable cost Variable Constant
Fixed cost Constant Variable
B. Linearity assumption – within the relevant range,
there is a strict linear relationship between the cost
a. Committed fixed cost – cost that is an
and cost driver. Costs may therefore be shown as
inevitable consequence of a previous
straight lines.
commitment; costs to which
 C. Time assumption – the cost behavior patterns E. Backflush costing – this is a streamlined cost
identified are true only over a specified period of accounting method that simplifies, speeds up and
time. Beyond this, the cost may show a different reduces accounting effort or procedures in
behavior pattern. accumulating product costs. Unlike in the traditional
Accountants should also be aware that a cost that is job order and process costing systems, backflush
considered variable in one organization may be costing eliminates the detailed tracking of the cost
considered fixed in another due, for example, to differing of work in process.
employment policies. F. Activity-based costing system – this costing system
uses multiple drivers to predict and allocate costs
DETERMINING THE COST FUNCTION FOR MIXED COSTS to products and services.
Mixed costs have variable and fixed cost components,
thus: FLOW OF COSTS IN A FIRM
Total cost (TC) = Fixed cost (FxC) + Variable Cost (VC) Cost flow refers to the manner in which costs move through
a firm specifically in its accounts and how such costs affect
Total variable cost varies directly with the activity level or
the firm’s statement of financial position and income
cost driver, thus:
statement.
Variable cost (VC) = Variable cost per cost driver (b) x Cost
driver (x) Merchandising Firm

Since total cost is linearly related to the activity level or cost Purchases P xxx
driver, the cost function may be expressed as: Freight or transportation in P xxx
Total P xxx
Y = a + bx Purchase discounts (xxx)
where: Y – is the total cost; a – is the total fixed cost; b – Purchase returns and allowances (xxx)
variable cost per cost driver; x – activity level or cost driver. Net purchases P xxx
Needless to say, purely fixed costs may be expressed as Y =
a and purely variable costs as Y = bx. Merchandise inventory, beginning P xxx
Net purchases P xxx
COST ACCOUNTING AND COST ACCOUNTING SYSTEMS Total goods available for sale P xxx
Cost accounting is that part of the accounting system that Merchandise inventory, ending (xxx)
measures costs for decision-making and financial reporting
Cost of goods sold P xxx
purposes. It involves the two processes namely:
Sales P xxx
A. Cost accumulation – involves collection of cost
Cost of sales (xxx)
data in some organized means in an accounting
Gross profit P xxx
system.
Operating expenses (xxx)
B. Cost assignment – involves tracing and allocating
Operating income P xxx
accumulated costs to cost objects.
Other income P xxx
Examples of cost accounting systems commonly used by Other expenses (xxx)
businesses include: Income before tax P xxx
A. Job order costing – this product costing system is Income tax (xxx)
used by firms that provide limited quantities of Net income P xxx
products or services unique to a customer’s needs
Manufacturing Firm
or specifications. Costs are assigned or traced to
individual products. For a manufacturing firm, the cost of goods sold is
computed differently as the goods purchased are not sold
Examples: automobile repair shops and
as is but rather transformed first before being sold to
tailoring/dressmaking business.
customers.
B. Process costing – this system is used by firms that
produce many units of a single product or nearly Raw materials inventory, beginning P xxx
identical products for long periods at a time. Net purchases P xxx
Examples: soft drinks company and toy Total raw materials available for use P xxx
manufacturers. Raw materials inventory, ending (xxx)
Direct materials used P xxx
C. Hybrid product-costing system – this costing system
Direct labor P xxx
incorporate features from two or more alternative
Manufacturing overhead P xxx
product costing systems such as job order and
Total manufacturing costs P xxx
process costing.
Work in process, beginning P xxx
Examples: clothing and food processing
Total costs placed into production P xxx
operations.
Work in process, ending (xxx)
D. Standard costing – this method uses predetermined Total cost of goods manufactured P xxx
factors to compute the standard cost of materials, Finished goods, beginning P xxx
labor and factory overhead so that such costs may Total goods available for sale P xxx
be assigned to the various inventory accounts and Finished goods, ending (xxx)
cost of goods sold and can be used with the other
Cost of goods sold P xxx
cost accounting systems.