Cost Accounting and Control 1

UNIT 1 – Cost Accounting Overview

Cost Accounting examines the cost structure of a

business. It does so by collecting information about the costs
incurred by a company’s activities, assigning selected costs to
products and services and other cost objects, and evaluating
the efficiency of cost usage.

Learning Outcomes

At the end of this unit, you should be able to:

• Differentiate Cost Accounting from Management Accounting and Financial

Accounting
• Classify costs in a manufacturing, service and merchandising business
• Calculate product costs in total and in units
• Prepare a Statement of Cost of Goods Manufactured
• Prepare a Cost of Goods Sold Statement
• Estimate costs using the various methods discussed in this module

You will be encountering a lot of cost terms in this module. Do

familiarize yourself with the classifications because these will serve as
the foundation all throughout this subject. Whatever form a business will
be, they will always entail cost. It is important for the costs to be
identified and classified properly in order to produce reliable reports.
Before we start, please answer the pre-test in the google form
link below:

https://docs.google.com/forms/d/e/1FAIpQLSdEBuuH0LYoGpd
emhb34uIeD6iPFvBfDe8K1hhwCogq5mp2Fg/viewform?usp=sf_link
 Cost Accounting and Control 2

The next section is the content of this unit. It contains vital information of the topics based
on the learning outcomes. Please read the content as a supplement to the prescribed readings in the
textbook.

Content

Before you go over this part of the module, please read Chapters
1-3 of the prescribed textbook: Cost Accounting and Control 2021 Edition
by Cabrera & Cabrera.

Presented below are different terms which are necessary all

throughout this subject. Make sure to study all of these words so you will
not get confused. Always remember to focus on learning for your future
and not just for passing our subject.

What is the goal of cost accounting?

The goal of cost accounting is to assist managers in achieving the maximum value for
their organization. One of the fundamental services of cost accounting is measuring the effects of
decisions on the value of the organization. As providers of information (accountants) or as the users
of information (managers), we have to understand how the information can and will be used to
increase value. Designing accounting systems that accomplish this goal, therefore becomes an
important task of cost accounting.

When you hear the word cost accounting, naturally, you would think that it is all related
to the costs of a company. This subject will teach you how to properly track, allocate, record and
report different costs. This is important because managers use cost accounting information to
choose strategy, to communicate it, and determine how best to implement it. Cost accounting is
mostly concerned with developing an understanding where a company earns and loses money, and
providing input into decision to generate profits in the future.
 Cost Accounting and Control 3

How is Cost accounting different from Financial Accounting and

Management Accounting?

A distinction is often made in practice between financial accounting, management accounting and
cost accounting. Study the definitions and graph on the next page.

Financial Accounting
- Involves the systematic recording of business transactions, governed by a body of
international financial reporting (IFRS) leading to the preparation of financial
statements for the use of various interested parties, internal as well as external.
Management Accounting

- Is concerned with providing financial information to persons within the organization to

enable them to make informed judgments and effective decisions which further the
organization’s goals.
Cost Accounting
- A subfield of accounting that records, measures and reports information about costs. A
cost is a sacrifice of resources and generally represented in the accounting system by
outlay of cash or promises to pay cash in the future or the expectation of the value of an
asset.
- Provides information to management accounting and financial accounting.

ACCOUNTING
Recording
Organizing
Summarizing
Reporting
FINANCIAL ACCOUNTING MANAGEMENT ACCOUNTING
• Reports to various interested parties • Reports to managers (internal)within
(external and internal): the organization for:
- Owners - Planning
- Lenders - Directing and motivating
- Tax authorities - Controlling
- Regulators - Performance and evaluation
- Managers
• Emphasis is on summaries of financial • Emphasis is on future-oriented data
consequences of past activities. needed in decision-making.
• Objectivity and verifiability of data are • Relevance is emphasized
emphasized.
• Precision of information is required. • Timeliness of information is required.
• Only summarized data for the entire
organization are prepared.
 Cost Accounting and Control 4

• Detailed segment reports about

• Must follow IFRS departments, products, customers, and
• Mandatory for external reports employees are prepared.
• Need not follow IFRS
• Not mandatory

RELATIONSHIP OF COST ACCOUNTING TO OTHER FIELDS OF STUDY

Cost accounting interfaces with many other fields of study. One of the primary uses of cost
accounting – valuing inventory and cost of gods sold for external reporting to shareholders – is part
of financial accounting. Cost accounting also provides data for use in decision models for finance,
operations management, and marketing. Cost accounting also relates to motivational behaviour
because it is used in planning and performance evaluation.

PRIMARY APPLICATION OF COST ACCOUNTING SYSTEMS

Take a look at the different applications of cost accounting systems:

I. Cost accounting systems provide data (e.g., financial statements) for compliance
with reportorial, contractual and regulatory requirements

When costs are used by outsiders, such as shareholders or creditors to evaluate

performance of top management and make investment decision about the
organization we say costs are used for financial accounting purposes.

Government agencies and commissions such as Bureau of Internal Revenue (BIR)

Social Security System (SSS) Securities and Exchange Commission (SEC) and so
forth require periodic reports for tax and other multiple compliance purposes.

II. Obtaining information for planning and control and performance evaluation

When costs are used inside the organization by managers to plan and evaluate
performance of operations or personnel or as a basis of decision making, we say
costs are used for managerial accounting purposes.

One of the most commonly used tool for planning and control is budgeting. A budget
forces management to look forward, to translate strategy into plans, to coordinate
and communicate within the firm and to provide a benchmark for evaluating
performance.
 Cost Accounting and Control 5

III. Analysing the relevant information for making decision

Business managers are constantly faced with problems of deciding what products to
sell, what production methods to, whether to accept special orders at special prices,
and so forth. Decision making is often a difficult task that is complicated by the
existence of numerous alternatives and massive amounts of data, some of which
may be relevant while others are not. Management and cost accountants help
managers identify what information is relevant and what information is irrelevant
when making decisions. Cost accounting data provides information which will then
be used for decision making, which is a managerial accounting purpose.

Organizational Environment

The cost accounting function is typically the responsibility of the controller. In most
corporations, the controller is the chief accounting officer. In some firms, the controller has the rank
of corporate vice president and reports directly to the company president. In others, the controller
and the treasurer may both report to a financial vice president who is responsible for both
accounting and financial affairs.

The chief accounting officer, the controller, is responsible for both external and internal
accounting reports. External reports include published financial statements and reports to taxing
authorities like the Bureau of Revenue Service and regulatory bodies like the Securities and
Exchange Commission (SEC), Bangko Sentral ng Pilipinas, Insurance Commission and so forth.

Internally, the controller is responsible for supplying management with accounting data for
planning, performance evaluation, and decision making and for overseeing the company's internal
control system. In addition, the controller maintains all cost and other accounting records,
including inventories, receivables, payables, and fixed asset accounts.

All managers in the organization, not just financial professionals, use cost accounting
information. Because our focus is on cost accounting and decision making, we will often be viewing
a decision from an operational manager's perspective.

Scope of Modern Cost Accounting

While the traditional role of cost accounting to record full product cost data for external
reporting and pricing remains important, cost accounting for decision making, planning and
performance evaluation has gained importance in reporting and pricing remains important, cost
accounting for decision making, planning and performance evaluation has gained importance in
recent decades. Consequently, cost accounting must actively work with management determine
what accounting information is needed.
 Cost Accounting and Control 6

A costing system typically accounts for costs in two basic stages:

1. Cost Accumulation

- Involves the collection of cost data in some organized way by means of an accounting
system. For example, a book publisher the purchases rolls of newsprint for printing
books accumulates the cost of individual rolls bought in any one month to obtain the
total monthly cost of paper.

2. Cost Assignment

- Beyond accumulating costs, the costing system traces direct costs and allocates indirect
costs to designated cost objects (such as the different books the publisher publishes).
This process enables the managers to calculate total costs and unit costs of products and
service and use this information for pricing, product mix and cost management
decisions.
The scope of cost accounting has broadened to include application of mathematical and statistical
techniques to cost analysis, consideration of how accounting affects managerial decisions models
used in finance, economics, and operations management; and examination of the motivational
impact of accounting

Cost accounting is no longer restricted to manufacturing companies. It is now used in virtually

every organization, including banks, schools, fast-food outlets, professional organizations, hospitals
and government agencies.

Word Bank for Terms, Concepts and Classifications

An understanding of cost terms and concepts provides the foundation of how to best use the
information provided as well as to avoid misuse of that information. Read, understand and
familiarize the concepts well because these terms will be repeatedly used all throughout our
semester.

❖ COST
The value foregone or sacrifice of resources for the purpose of achieving some
economic benefit which will promote the profit-making ability of the firm. A cost is incurred
when a resource is used for some purpose. It is also an outlay or expenditure of money to
acquire goods and services that assist in performing operations.

❖ COST POOLS
These are costs collected into meaningful groups. Cost pool may be classified
a. By type of cost (labor cost in one pool, material cost in another)
b. By source (Department 1, department 2 and so on
c. By responsibility (manager 1, manager 2 and so on)
 Cost Accounting and Control 7

❖ COST OBJECT
This is any product, service or organizational unit to which costs are assigned for
some management purpose. Products and services are generally cost objects, while
manufacturing departments are considered either cost pools or cost objects, depending on
whether management’s main focus is on costs of the products or for the production
department. Any item where costs can be traced and that has a key role in management
strategy can be considered a cost object.

Table 1.1 shows examples of several different types of cost objects.

Table 1.1: Examples of Cost Objects

Cost Object Illustration

Program An athletic program of a university
Department A department within a DENR that studies air
emissions standards
Activity A test to determine the quality level of
television set
Brand Category All soft drinks sold by a Pepsi-Cola bottling
company with “Pepsi” in their name
Customer All product purchased by Landmark (the
customer) from Purefoods Inc.
Project A special sportscar assembled by Toyota
Motors
Service An airline flight from NAIA to Hongkong
Product A motorcycle

❖ COST DRIVERS
This is any factor that has the effect of changing the level of total cost. A critical first
step for achieving a competitive advantage is to identify the key cost drivers in a firm or
organization. The management of the key cost drivers is essential for a firm that competes
on the basis of cost leadership.
Table 1.2: Examples of Cost Drivers and business functions in a value chain

Business Function Cost Driver

Research and Development • Number of research projects
• Manpower hours on a project
• Technical difficulties of projects

Design of products, services and processes • Number of products in design

• Number of parts per product
 Cost Accounting and Control 8

• Number of engineering hours

Production • Number of units produced

• Direct manufacturing labor costs
• Number of setups
• Number of engineering change orders

Marketing • Number of advertisements run

• Number of sales personnel
• Peso sales

Distribution • Number of items distributed

• Number of customers
• Weight of items distributed

Customer Service • Number of service calls

• Number of products serviced
• Hours spent servicing products

❖ COST ASSIGNMENT
The process of assigning costs to cost pools or from cost pools to cost objects.

❖ COST ALLOCATION
The assignment of indirect costs to cost pools. Allocation Bases are cost drivers used
to allocate costs.

CLASSIFICATION OF COSTS

Cost classifications are necessary for the development of cost information to serve the needs of
management. Understanding these concepts and classifications enables the managerial accountant
to provide appropriate cost data to the managers who need it.

A. Costs classified by Nature or Management Function

1. Manufacturing Costs
-are all the costs associated with production of goods. They are frequently classified as
direct materials, direct labor, and factory overhead. Since costs attach to the product or
groups of products as they are manufactured, expenditures, regardless of their nature,
usually are capitalized as inventory assets and do not become "expired costs" or "expenses"
until the goods are sold.
 Cost Accounting and Control 9

a. Direct Materials

All raw material costs that become an integral part of the finished product and that can be
conveniently and economically assigned to specific units manufactured.

Materials cost includes the invoice price plus other costs paid to the vendor, shipping costs,
sales taxes, duty, cost of delivery containers and pallets (less net of return refunds), and royalty
payment based on direct materials quantities. Trade discounts and cash discounts (if they exceed
reasonable interest rates) should reduce materials costs.
Materials cost should also include scrap, waste, and normally anticipated defective units that
occur in the ordinary course of the production process. Unanticipated quantities of scrap,
shrinkage, waste, or defective units should be included in manufacturing overhead or expensed in
the period incurred. Also, routine quality assurance samples that are destroyed as part of testing
should be classified as materials. However, nonroutine quality assurance samples are taken due to
manufacturing problems and cost of marketing samples should not be added to materials costs.

b. Direct labor
All labor costs related to time spent on products that can be conveniently and economically
assigned to specific units manufactured.
Estimates of direct labor quantities and unit prices may be sufficiently accurate to be
considered "specifically identified" with a cost object.

c. Manufacturing Overhead

Manufacturing overhead, the third element of manufacturing cost, includes all costs of
manufacturing except direct materials and direct labor. Indirect materials, indirect labor, property
taxes, insurance, supervisor's salaries, depreciation of factory building and factory equipment, and
power are examples of factory overhead. Costs of operating service departments are also part of
overhead. Service departments are those that do not work directly on manufacturing products but
are necessary for the manufacturing process to occur. An example is equipment-maintenance
departments.

• Indirect materials -ninclude materials and supplies used in the

manufacturing operation that do not become part of the product, such as oil
for the machinery and cleaning fluids for the custodian.
• Indirect labor - Labor costs that cannot be identified or traced to specific
units manufactured. Examples include supervision, inspection, maintenance,
personnel and material handling.

To summarize, manufacturing costs include direct materials, direct labor and

manufacturing overhead. Direct labor and overhead are often called conversion costs since
they are the costs of "converting or transforming" raw material into finished products.
Direct materials and direct labor are often referred to as prime costs.
 Cost Accounting and Control 10

Other manufacturing overhead costs include overtime premiums and the cost of idle
time. An overtime premium is the extra compensation paid to an employee who works
beyond the time normally scheduled.

2. Nonmanufacturing Costs
- generally include costs related to selling and other activities not related to the
production of goods.

a. Marketing costs
Marketing or selling costs include all costs associated with marketing or selling
a product or all costs incurred by the marketing division from the time the
manufacturing process is completed until the product is delivered to the customer or
all costs necessary to secure customer orders and get the finished product or service
into to hands of the customer. These costs also called order-getting and order-filing
costs. Examples of marketing costs are advertising, shipping, sales commissions and
storage costs.

b. General and administrative costs

General administrative costs include all executive, organizational and clerical
costs associated with the general management of the organization rather than with
manufacturing, marketing or selling.

3. Production Costs in Service Industry Firms and Nonprofit Organizations

Service industry firms such as schools, hotels, banks, airlines, accounting firms, and
automotive repair shops and many nonprofit organizations are also engaged in production.
What distinguishes these enterprises from manufacturers is that a service is consumed as it
is produced, whereas a manufactured product can be stored in inventory while less
commonly applied in service firms, the same ost classifications used in manufacturing
companies can be applied. For example, an automotive repair shop produces repair
services. Direct materials include such costs as new parts installed to replace the worn out
parts, paint and other materials used. Direct labor includes the wages paid to the service
crew. Overhead costs include depreciation of equipment and other tools used and rental
expense.

Recording and classifying costs is important not only for manufacturing firms but
for service industry firms and nonprofit organizations as well. Cost analysis is necessary in
pricing, banking and insurance services, hotel and travel rental agencies, setting tuition fees
in schools and many more.
As these organizations grow in number and in scope of business operations
applying managerial accounting to their activities take an even greater importance.
 Cost Accounting and Control 11

B. Costs classified according to the Timing of Recognition as Expense

An expense is defined as the cost incurred when an asset is used up or sold for the purpose of
generating revenue. The terms product cost and period cost are used to describe the timing
with which various expenses are recognized.

1. Product Costs
- include all the costs that are involved in acquiring or making a product. Also called
inventoriable costs, they are costs that "attach" or cling to the units that are produced and
are reported as assets until the goods are sold. In the case of manufactured goods, these
costs consist of direct materials, direct labor, and manufacturing overhead. So initially,
product costs are assigned to an inventory account on the statement of financial position.
When the goods are sold, the costs are released from inventory as expenses (typically called
cost of goods sold) and matched against sales revenue. This means that a product cost such
as direct materials or direct labor might be incurred during one period but not treated as an
expense until s following period when the completed product is sold.

2. Period Costs Period costs are all the costs that are identified with accounting periods and
not included in product costs. These costs are expensed on the income statement in the
period in which they are incurred. Period costs are not included as part of the cost of either
purchased or manufactured goods. Examples of period costs include selling and
administrative expenses such as sales commissions, office rent, and transportation
expenses.

C. Costs classification on Financial Statements

The financial statements prepared by a manufacturing company are more complex than the
statements prepared by a merchandising company. Manufacturing companies are more
complex business firms than merchandising companies because the manufacturing company
must produce its goods as well as market them. The production process gives rise to many costs
that do not exist in a merchandising company. The manufacturing company's product costs
include not only the cost of purchasing but also the cost of converting materials into saleable
products. These product costs are counted as assets until the product is sold and the revenue
from the sales is recorded on the income statement.

The Statement of Financial Position

The statement of financial position of a manufacturing company is similar to that of a

merchandising company. However, the inventory accounts differ between the two types of
companies.

A merchandising company has only one class of inventory called merchandise inventory. These
are goods purchased from suppliers that are awaiting resale to customers.
In contrast, manufacturing companies have three classes of inventories, namely, raw materials,
work in process and finished goods.
 Cost Accounting and Control 12

Raw materials are materials that are used to make a product.

Work in process consists of units of product that are only partially complete and will require
further work before they are ready for sale to a customer.

Finished goods consist of units of product that have been completed but have not yet been sold
to customers.

The overall inventory figure is usually broken down into these three classes of inventory in
footnote to the financial statements.

The Income Statement

At first glance, the income statement of merchandising and manufacturing firms are very
similar. The only apparent difference is in the captions of some of the entries in the computation
of cost of goods sold.

The cost of goods sold for a merchandising company is determined as follows:

Beginning merchandise inventory Pxx

Add: Purchases xx
Total available for sale Pxx
Less: Ending merchandise inventory xx
Cost of goods sold Pxx

The cost of goods sold for a manufacturing company is determined as follows:

Beginning finished goods inventory Pxx

Add: Cost of goods manufactured xx
Total available for sale Pxx
Less: Ending finished goods inventory xx
Cost of goods sold Pxx

The cost of goods manufactured contains the three elements of product costs namely direct
materials, direct labor and manufacturing overhead.
 Cost Accounting and Control 13

Illustrative Statements of a Merchandising Company

ABC Trading Company

Income Statement
For the Year Ended December 31, 20X1
Sales P1,000,000
Cost of goods sold:
Beginning inventory P100,000
Add: Purchases 650,000
Goods available for sale P750,000
Ending inventory 150,000 600,000
Gross margin P400,000
Less operating expenses:
Selling expense P100,000
Administrative expense 200,000 300,000
Net income P100,000

ABC Trading Company

Current Assets of the Statement of Financial Position
December 31, 20X1
Current Assets:
Cash P10,000
Accounts Receivable 60,000
Merchandise inventory 150,000
Prepaid expenses 5,000
Total current assets P225,000

Illustrative Statements of a Manufacturing Company

XYZ Company
Income Statement
For the Year Ended December 31, 20X1

Sales P1,500,000
Cost of goods sold:
Beginning finished goods inventory P125,000
Add: Cost of goods manufactured 850,000
Goods available for sale P975,000
Ending finished goods inventory 175,000 800,000
Gross margin P700,000
Less operating expenses:
Selling expense P250,000
Administrative expense 300,000 550,000
Net income P150,000
 Cost Accounting and Control 14

XYZ Company
Statement of Cost of Goods Manufactured
For the Year Ended December 31, 20X1
Direct materials
Direct materials inventory, Jan. 1, 20X1 P30,000
Purchases of direct materials 210,000
Total direct materials available P240,000
Direct materials inventory, Dec. 31, 20X1 15,000
Direct materials used P225,000
Direct labor 250,000
Manufacturing overhead
Indirect materials P35,000
Factory utilities 70,000
Factory supervision 70,000
Property taxes on factory equipment 20,000
Factory maintenance and repairs 20,000
Depreciation of plant and equipment 90,000
Total manufacturing overhead 305,000
Total manufacturing costs P780,000
Work in process inventory, Jan. 1, 20X1 130,000
Total P910,000
Work in process inventory, Dec. 31, 20X1 60,000
Cost of goods manufactured P850,000

XYZ Company
Current Assets Section of the Statement of Financial Position
December 31, 20X1
Current Assets:
Cash P15,000
Accounts receivable 100,000
Inventories:
Raw materials P15,000
Work in process 60,000
Finished goods 175,0000 250,000
Prepaid expenses 10,000
Total current assets P375,000
 Cost Accounting and Control 15

Illustrative Statements of a Service Company

EFG Consulting Company

Income Statement
For the Year Ended December 31, 20X1
Revenues
Fees for professional service P500,000
Less: Direct costs
Employees compensation & fringe benefits 245,000
Contribution to Indirect Cost 255,000
Less: Indirect costs
Rent of office facilities 30,000
Training and research 20,000
Personnel recruiting 10,000
Professional insurance and litigation 6,000
Other 25,000
Total 91,000
Operating income P164,000

EFG Consulting Company

Current Assets of the Statement of Financial Position
December 31, 20X1
Current Assets:
Cash P25,000
Accounts receivable 63,000
Unbilled services, at estimated billable rate 50,000
Prepaid expenses 14,000
Total current assets P152,000

D. Cost classification for Predicting Cost Behavior

Cost behavior refers to how a cost will react or respond to changes in the business activity.
As the activity level rises and falls, a particular cost may rises and falls as well - or it may remain
constant. For planning purposes, a manager must be able to anticipate which of these will
happen; and if a cost is expected to change, the manager must know by how much it will change,
To help make such distinction, costs are often categorized as variable, fixed or semi-variable.

a. Variable Costs
- Costs that change directly in proportion to changes in activity (volume) Direct
labor and direct materials are examples of variable costs.
 Cost Accounting and Control 16

b. Fixed Costs
-Costs that remain unchanged for a given time period regardless of change in
activity (volume). Rent, insurance on property, maintenance, and repairs of
buildings, and depreciation of factory equipment are examples of fixed costs.
c. Semivariable Costs or Mixed Costs

-Costs that contain both fixed and variable elements. Examples of social security
taxes, materials handling, personnel services, heat, light, and power. These cost
elements must be divided into their proper elements.

E. Costs classified by Types of Inventory

a. Raw Materials Inventory

The cost of all raw material and production supplies that have been purchased
but not used at the end of the accounting period.

b. Work-in-process Inventory
The cost associated with goods partially completed at the end of the accounting
period

c. Finished Goods Inventory

Cost of completed goods that have not been sold at the end of the accounting
period.

d. Merchandise Inventory
Cost of purchased merchandise by retailers / wholesales that have not been sold
at the end of the accounting period.
F. Costs classification according to Traceability to Cost Objective

a. Direct costs (traceable; separable)

Costs that can be economically traced to a single cost object (1.e. product,
department or unit)
b. Indirect costs
Costs that are not directly or easily traceable to the cost object (.e. product,
department, etc.)
G. Costs classification according to Managerial Influence

a. Controllable cost
Cost that is subject to significant influence by a particular manager within the
time period under consideration.

b. Noncontrollable cost
Cost over which a given manager does not have a significant influence.
 Cost Accounting and Control 17

H. Cost Terminologies Used for Planning and Control

a. Standard Costs
A predetermined cost estimate that should be attained; usually expressed in
terms of costs per unit.

b. Budgeted Cost
Used to represent the expected/planned cost for a given period. For example, a
company plans to manufacture 1,000 units of product X, which has a standard cost
per unit of P4, would have budgeted cost for the period of P4,000 for product X.

c. Absorption Costing
A costing method that includes all manufacturing costs - direct materials, direct
labor, and both variable and fixed manufacturing overhead - in the cost of a unit of
product. It is also referred to as the full cost method.

d. Direct Costing
A type product costing where fixed costs are charged against revenue as
incurred and are not assigned to specific units of product manufactured Also
referred to as variable costing.

e. Information Costs
Costs of obtaining information.

f. Ordering Costs
Costs that increase with the number of orders placed for inventory.

g. Out-of-pocket Costs
Costs that must be met with a current expenditure or cash outlay.
I. Cost classification according to a Time-frame Perspective

a. Committed Cost
Cost that is the inevitable consequence of a previous commitment.

b. Discretionary Cost (programmed; managed cost)

Cost for which the size or the time of incurrence is a matter of choice.
J. Costs classified according to Time Period for Which the Cost is Incurred

a. Historical costs (past costs)

Costs that were incurred in a past period.
 Cost Accounting and Control 18

b. Future costs
Budgeted costs that are expected to be incurred in a future period.
K. Costs classifications for Decision-making and other Analytical Purposes

a. Relevant Costs
Future costs that are different under one decision alternative than under
another decision alternative.

b. Incremental Costs
The difference in cost between two or more alternatives. In evaluating a given
alternative, incremental cost is the additional cost to determine the feasibility of this
particular alternative. To be an incremental cost, the cost must be a future cost and
be different under various alternatives.

c. Sunk Costs
Past costs that have been incurred and are irrelevant to a future decision.

d. Opportunity Costs
The value of the best alternative foregone as the result of selecting a different
use of resource or by choosing a particular strategy.

e. Marginal Costs
Costs associated with the next unit or the next project or incremental cost
associated with an additional project as opposed to the next discrete unit.

f. Value Added Costs

Costs that add value to the product. These costs result from activities that me
necessary to satisfy the requirements of the consumer. Effort should be made to
eliminate those costs that do not add value to the product, such as storage and
materials handling.

Illustrative Problem on Cost Classifications

Bettina Cabrera is the production manager of a ready-to-wear manufacturing outfit.

A decision needs to be made about the type of clothing material or fabric to be used to make
a shirt. The fabric that has been used in the previous production cost P40 per yard but it is
not available currently. Similar material from another supplier will cost P50 per yard.
 Cost Accounting and Control 19

The cost of the fabric can be classified as follows:

1. Time period
P40.00 historical cost
P50.00 future cost

2. Management function
The cost of the fabric is a manufacturing cost.

3. Accounting treatment
Whatever is paid for the fabric will be capitalized as a product cost and
carried in inventory until it is sold.

4. Traceability to product
The fabric is a direct cost because it represents a significant portion of the
cost of the product and can be traced to a specific unit of finished product.

5. Cost behavior
Both the P40.00 and P50.00 cost per yard are variable costs. As the number
of yards purchased increases, the total fabric cost increases proportionately.

6. Decision significance
The P50.00 cost is relevant because it can be compared with the price of
other fabrics of similar quality to select the best alternative. The P40.00 cost is
irrelevant.

7. Managerial influence
The cost of the fabric to be acquired is a controllable cost since Ms. Cabrera
has the authority to make production decisions.

8. Others
The fabric is an out-of-pocket cost associated until producing additional
skirts which will involve cash outlay in its acquisition.
 Cost Accounting and Control 20

Cost Behavior: Analysis and Use

DEFINITION OF COST BEHAVIOR

Cost behavior means how a cost will react as changes take place in the level of business
activity Managers who understand how costs behave are better able to predict what costs will be
under various operating circumstances. An understanding of cost behavior under varying
conditions is essential to adequate decision making in the planning and control of firm activity.

IMPORTANCE OF UNDERSTANDING COST BEHAVIOR

Planning requires that management make decisions based in part on expectations as to the future.
These expectations should be based on data relevant to the decision objectives, gathered and
analyzed in a competent, unbiased fashion Failure in this activity could mean displacement costs
due to unexpected events.

Control is the process of using feedback information for comparison with expectations and the
implementation of actions on the basis of that comparison.

Cost Analysis is an integral part of the planning and control function. The key to effective cost
prediction lies in an understanding of cost behavior patterns. This chapter reviews and discusses in
greater depth variable costs, fixed costs and mixed costs which were introduced earlier.

TYPES OF COST BEHAVIOR PATTERNS

1. Variable Costs

Variable costs are those costs that change in total as the level of activity changes in
the short run and within the relevant range. To the economist, the short run is the time
period long enough to allow management to change the level of production or other activity
within the constraints of current total productive or operating capacity. Furthermore, the
estimates of variable and other costs are applicable only if the contemplated level of activity
is within the relevant range. Relevant range is the range activity within which assumptions
relative to variable cost and fixed cost behavior are valid. Variable cost per unit is assumed
to remain constant within this range. For a cost to be variable, it must be variable with
respect to its activity base. An activity base is a measure of whatever causes the incurrence
of variable cost. An activity base is sometimes referred to as a cost driver. Some of the most
common activity drivers are units sold, units produced, direct labor-hours and machine
hours. Other activity bases (cost drivers) might include the number of miles driven by
 Cost Accounting and Control 21

salespersons, the number of pounds of laundry cleaned by a hotel, the number of calls
handles by technical support staff at a software company, and the number of beds occupied
in a hospital.

Examples:

In a Manufacturing Company: Direct materials

Direct labor
Some manufacturing overhead such as indirect materials,
materials handling costs, energy costs, supplies
Distribution costs

Sales commission

In a Merchandising company: Cost of Sales

Sales commission

In a Service Organization: Direct labor and materials used to perform the services such
as auto repair and consulting; supplies, travel

2. Fixed costs

Fixed costs are costs that remain constant in total regardless of changes in the level
of activity within the relevant range: Fixed costs however may change due to some outside
force, such as price changes. Fixed cost per unit will react inversely with change in activity.
Fixed costs decrease per unit as the activity level rises and increase per unit as the activity
level fall.

Types of Fixed Costs

Fixed costs are sometimes referred to as capacity costs, since they result from
outlays made for buildings, equipment, skilled professional employees, and other items
needed to provide the basic capacity for sustained operations. For planning purposes, fixed
costs can be viewed as being either committed or discretionary.
 Cost Accounting and Control 22

a. Committed fixed costs

- relate to the investment in facilities, equipment, and the basic organizational
structure of a firm. Examples of such costs include depreciation of buildings and
equipment, taxes on real estate, insurance, and salaries of top management and
operating personnel. The two key characteristics of committed fixed costs are that (1)
they are long term in nature, and (2) they can't be significantly reduced even for short
periods of time without seriously impairing the profitability or long-run goals of the
organization. Even if operations are interrupted or cut back, the committed fixed costs
will still continue largely unchanged.

b. Discretionary fixed costs (often referred to as managed fixed costs)

-usually arise from annual decisions by management to spend in certain fixed cost
areas. Examples of discretionary fixed costs include advertising, research, public
relations, management development programs, and internships for students. The most
important characteristic of discretionary fixed costs is that management is not locked
into a decision regarding such costs. They can be adjusted from year to year or even
perhaps during the course of a year if circumstances demand such a modification.

Fixed Costs and the Relevant Range

The concept of relevant range is also important in understanding fixed costs --

particularly discretionary fixed costs. The levels of discretionary fixed costs are typically
decided at the beginning of the year and depend on the support needs of planned programs
such as advertising and training. The scope of these programs will depend, in turn, on the
overall anticipated level of activity for the year. At very high levels of activity, programs are
usually broadened or expanded.

For example, if the company hopes to increase sales by 25%, it would probably plan
for much larger advertising costs than if no sales increase were planned. So the planned
level of activity might affect total discretionary fixed costs. However, once the total
discretionary fixed costs have been budgeted, they are unaffected by the actual level of
activity. For example, once the advertising budget has been decided on and has been spent,
it will not be affected by how many units are actually sold. Therefore, the cost is fixed with
respect to the actual number of units sold.

Examples of Fixed Costs:

Rent, insurance, property taxes, supervisory salaries, straight-line depreciation,

administrative salaries and advertising.
 Cost Accounting and Control 23

3. Mixed Costs (Semivariable Costs)

A mixed cost in one that contains both variable and fixed cost elements. Mixed
costs are also known as semivariable costs. Common Examples are: Maintenance Costs,
Electric Utility Costs.

The relationship between mixed cost and the level of activity also be expressed in
the following equation:

Y = a + bX

Where:

Y = The total mixed cost (the dependent variable)

a = The total fixed cost (the vertical intercept of the line)
b = The variable cost per unit of activity (the slope of the line)

X = The level of activity (the independent variable)

The independent variable is also called the explanatory variable or cost driver. In
cost estimation, we identify some independent variable (the activity) and the functional
relationship that permit computation of the corresponding value of the dependent variable
(the costs).

Cost Estimation

The Analysis of Mixed Costs

The fixed portion of mixed cost represents the basic, minimum cost of just having a service
ready and available for use while the variable portion represents the cost incurred for the actual
consumption of the service. The variable element varies in proportion to the amount of service that
is consumed.

How does management go about in estimating the fixed and variable components of a mixed
cost? The basic idea in cost estimation is to estimate the relation between costs and the variables
(factors) affecting the costs.
 Cost Accounting and Control 24

We will discuss the methods of estimating the relation between cost behavior and activity
levels that are commonly used in practice as well as a brief overview of the theory and some
important considerations for their application.

These are:

1. Account Analysis method

2. Industrial Engineering method or Work Measurement method
3. Quantitative Analysis of Current and Past Costs Relationships
a. High-Low Method
b. Regression Analysis Method
i. Scattergraph or Visual fit method
ii. The Least-squares Regression method
It is possible that results will differ from method to method. Consequently, more than one
approach is often applied so that results can be compared. Line managers should apply their own
best judgment, modifying the estimates submitted by the controller's staff, a final step in the
estimation process.

The following is a summary for the cost estimation:

Method Strengths Weaknesses

Account Analysis – makes use of the Provides a detailed Subjective
experience and judgment of managers and expert analysis of the
accountants who are familiar with company cost behaviour in
operations and the way costs react to changes each account.
in activity level.
Engineering Method – estimates cost Based on studies of No particularly useful
functions by analysing the relationship what future costs when the physical
between inputs and outputs in physical forms. should be rather than relation between
what past costs have inputs and outputs is
been. indirect.
High-Low Method – based on costs observed Simple to apply Uses only two data
at both the high and low levels of activity points which may not
within the relevant range. produce accurate
results.
Scattergraph Method – a rough guide for cost Uses all the The fitting of the line
estimation which plot the cost against past observations of cost to the observations is
activity levels. data. Relatively easy subjective. Difficult to
to understand and do where several
apply. independent variables
are to be used.
Least-squares Regression Method – a Uses all of the The regression model
statistical technique which is often used in observations of cost requires that several
data. relatively strict
 Cost Accounting and Control 25

separating mixed costs into their fixed and The line is assumption be
variable components. statistically fit to satisfied for the results
observations. to be valid.
A measure of the
goodness of fit of the
line to the
observations is
provided.
Relatively easy to use
with the computers
and sophisticated
calculators.

Note: For this semester, we will only include the high-low method for problem solving. Please
refer to the Exercises Page for detailed problems. Take note though for accountancy students that
the following topics might be included in the board exam: Least-squares method, Correlation
Analysis, and the learning curve theory.
 Cost Accounting and Control 26

Summary of Equations for Module 1

1. Total Product Cost = Direct Materials + Direct Labor + Manufacturing Overhead

2. Per-unit Product Cost = Total Product Cost

Number of Units Produced

3. Prime Cost = Direct Materials + Direct Labor

4. Conversion Cost = Direct Materials + Direct Labor

5. Ending Inventory of Materials = Beginning Inventory of Materials + Purchases – Direct

Materials Used in Production

6. Gross Margin = Sales Revenue – Cost of Goods Sold

7. Operating Income = Gross Margin – Selling and Administrative Expense

8. Total Variable Costs = Variable Rate x Units of Output

9. Total Cost = Total Fixed Cost + Total Variable Cost

10. Total Cost = Total Fixed Cost + (Variable Rate x Units of Output) ; Y=a+bX

11. The following shows how to use the High-Low Method

a. Obtain relevant data on past costs and related actual activity levels. Eliminate the
outliers.
b. Estimate the variable cost per unit or rate using the following equation.

Variable Cost rate or per unit = Cost at highest activity – Cost at lowest activity
Highest activity – Lowest activity
c. Compute the fixed cost as follows
Fixed Cost=Total Cost at highest activity – [Variable Cost per unit x Highest activity in units]
Fixed Cost=Total Cost at lowest activity – [Variable Cost per unit x Lowest activity in units]

The following are the common abbreviations:

DM – Direct Materials COGM- Cost of Goods Manufactured
DL – Direct Labor COGS – Cost of Goods Sold
MOH – Manufacturing Overhead TC – Total Cost
RM – Raw Materials TVC – Total Variable Cost
WIP – Work in Process TFC – Total Fixed Cost
FG – Finished Goods
 Cost Accounting and Control 27

Problem Examples for Module 1

1. Cost of Computation under different Activity Levels

TOP Pickups in an up-scale, higher-priced, specialty pickup truck maker based in Laguna.
The management accountant for TOP Pickups compiled information for various levels of
pickup truck output:

Pickup Truck Output

3,000 trucks 6,000 trucks 9,000 trucks

Variable production costs P29,640,000 d. i.

Fixed production costs a. P39,200,000 j.

Variable selling costs 4,500,000 e. k.

Fixed selling costs 13,660,000 13,660,000 l.

Total costs b. f. m.

Selling price per truck 46,000 40,100 35,900

Unit cost 29,000 g. n.

Profit per truck c. h. o.

Required:
Rounding all calculations to the nearest peso, fill in the blanks with the correct figures.

Solution:
a. Since there is no information regarding the change in fixed cost, we will expect
3,000-9,000 trucks to be in relevant range. Under 6,000 trucks, you can see that
the total fixed costs is P39,200,000. It must be the same for the other activity
levels. Answer: P39,200,000.
b. TC = Product Cost + Period Cost
TC = (VPC + FPC) + (VSC + FSC)
TC = (29,640,000+39,200,00) + (4,500,000 + 13,660,000)
Answer: TC = P87,000,000
c. Profit per truck = Sales per unit – Cost per unit
Profit per truck = P46,000 – P29,000
Answer: Profit per truck = P17,000
 Cost Accounting and Control 28

d. Remember that the variable cost per unit is constant. It will never change within
the relevant range. Therefore, you can use the data at 3,000 trucks to compute the
variable cost per unit:
Variable Production Cost per unit = Total Variable Production Cost/Activity Level
Variable Production Cost per unit = P29,640,000/3,000 trucks
Variable Production Cost per unit = P9,880/truck
Now you can use that information to get the total production costs at 6,000 trucks:
Variable production costs = P9,880/truck *6,0000 trucks
Answer: Variable Cost per unit = P59,280,0000
e. Using the same formula with d but this time for selling costs:
Variable Selling Cost per unit = Total Variable Selling Cost/Activity Level
Variable Selling Cost per unit = P4,500,000/3,000 trucks
Variable Selling Cost per unit = P1,500/truck
Now you can use that information to get the total production costs at 6,000 trucks:
Variable Selling costs = P1,500/truck *6,0000 trucks
Answer: Variable Selling Cost per unit = P9,000,0000
f. TC = Product Cost + Period Cost
TC = (VPC + FPC) + (VSC + FSC)
TC = (59,280,000+39,200,00) + (9,000,000 + 13,660,000)
Answer: TC = P121,140,000,000
g. Unit Cost = Total Cost/Activity Level
Unit Cost = P121,140,000/6,000 trucks
Answer: P20,190
h. Profit per truck = Sales per unit – Cost per unit
Profit per truck = P40,100 – P20,190
Answer: Profit per truck = P19,910

For letters i-o, I will give you the answer and you must be able to solve them by
now. Should you have any inquiries, don’t hesitate to ask me anytime within our
class hours.

i. P88,920,000
j. 39,200,000
k. 13,500,000
l. 13,660,000
m. P155,280,000
n. P17,253
o. P18,647

2. Calculating Product Costs in Total and Per unit

Why: Product costs are essential to management control and decision making. Managers
use product costs to create budgets and analyses. Product costs within manufacturing can
then be contrasted with period costs incurred outside of manufacturing.

Information:
 Cost Accounting and Control 29

Blue Company makes blue jeans. Last week, direct materials (denim, thread, zippers
and rivets) costing P48,000 were put into production. Direct labor of P30,000 (50 workers x
40 hours x P15 per hour) was incurred. Overhead equalled P72,000. By the end of the week,
Blue had manufactured 30,000 pairs of jeans.

Required:
a. Calculate the total product cost for last week.
b. Calculate the cost of one pair of jeans that was produced last week.

Solution:
a. Direct materials P48,000
Direct labor 30,000
Overhead 72,000
Total product cost P150,000

b. Per-unit Product Cost = P150,000/30,000 = P5

3. Calculating Prime Cost and Conversion Cost in Total and Per Unit

Why: Managers often categorize product costs into either prime or conversion in nature to
compare relative cost of manufacturing inputs (i.e., direct materials and direct labor) versus
processing (i.e., direct labor and manufacturing overhead).

Information: Blue Company makes blue jeans. Last week, direct materials (denim, thread,
zippers and rivets) costing P48,000 were put into production. Direct labor of P30,000 (50
workers x 40 hours x P15 per hour) was incurred. Overhead equalled P72,000. By the end
of the week, Blue had manufactured 30,000 pairs of jeans.

Required:
a. Calculate the total prime cost for last week.
b. Calculate the per-unit prime cost.
c. Calculate the total conversion cost for last week.
d. Calculate the per-unit conversion cost.

Solution:
a. Direct Materials P48,000
Direct Labor 30,000
Total prime cost P78,000

b. Per-Unit Prime Cost = P78,000/30,000 = P2.60

c. Direct labor P30,000

Overhead 72,000
Total conversion cost P102,000

d. Per-unit Conversion Cost = P102,000/30,000units = P3.40

 Cost Accounting and Control 30

Note: Remember that prime cost and conversion cost do NOT equal total product cost. This
is because direct labor is part of BOTH prime cost and conversion cost.

4. Calculating the Direct Materials used in Production

Why:
The primary use of calculating the direct materials used in production, is to serve a
the first number in calculating the cost of goods manufactured. Direct materials used in
production also show managers the difference between the amount of materials purchased,
and the amount of materials used in manufacturing for the period.

Information:
Blue makes blue jeans. On May 1, Blue had P68,000 of materials in inventory. During
the month of May, Blue purchased P210,000 of materials. On May 31, materials inventory
equalled P22,000.

Required:
Calculate the cost of direct materials used in production for the month of May.

Solution:

Materials inventory, May 1 P 68,000

Purchases 210,000
Materials inventory, May 31 (22,000)
Direct materials used in production P256,000

5. Calculating Cost of Goods Manufactured

Why: The primary use for the statement of cost of goods manufactured is for external
financial reporting.

Information:
Blue makes blue jeans. During the month of May, Blue purchased P210,000 of materials and
incurred direct labor cost of P135,000 and manufacturing overhead of P150,000. On May
31, materials inventory equalled P22,000. Inventory information is as follows:

May 1 May 31
Materials P68,000 P22,000
Work in process 50,000 16,000

Required:
Calculate the cost of goods manufactured for the month of May.
 Cost Accounting and Control 31

Solution:

Direct materials used in production* P256,000

Direct labor 135,000
Manufacturing overhead 150,000
Total manufacturing cost for May P541,000
WIP, May 1 50,000
WIP, May 31 (16,000)
Cost of goods manufactured P575,000
*DM = P68,000 + P210,000 – P22,000 = P256,000

6. Calculating Cost of Goods Sold

Why: The primary use for the statement of cost of goods sold is for external financial
reporting. It is a critical input to the income statement.

Information:
Blue makes blue jeans. During the month of May, 115,000 pairs of jeans were
complete at a cost of goods manufactured of P575,000. Suppose that on May 1, Blue had
10,000 units in the finished goods inventory costing P50,000 and on May 31, the company
had 26,000 units in the finished goods inventory costing P130,000.

Required:
a. Prepare a cost of goods sold statement for the month of May.
b. Calculate the number of pairs of jeans that were sold during May.
Solution:

a. COGS Statement
Blue Company
Cost of Goods Sold Statement
For the Month of May
Cost of goods manufactured P575,000
Finished goods inventory, May 1 50,000
Finished goods inventory, May 31 (130,000)
Cost of goods sold P495,000

b. Number of units sold:

Finished goods inventory, May 1 10,000
Units finished during May 115,000
Finished goods inventory, May 31 (26,000)
Units sold during May 99,000
 Cost Accounting and Control 32

7. Preparing an Income Statement for a Manufacturing Firm

Why: The primary use for the income statement is for external financial reporting. Investors
and outside parties use it to determine the financial health of a firm.

Information:
Recall the Blue sold 99,000 pairs of jeans during the month of May at a total cost of
P495,000. Each pair sold at a price of P8. Blue also incurred two types of selling costs:
commissions equal to 10% of the sales price, and fixed selling expenses of P120,000.
Administrative expense totalled P85,000.

Required: Prepare an income statement for Blue for the month of May.

Solution:

Blue Company
Income Statement
For the Month of May

Sales revenue (99,000 x P8) P792,000

Cost of goods sold 495,000
Gross margin P297,000
Less:
Selling expense
Commissions (0.10 x P792,000) P79,200
Fixed selling expense 120,000 199,200
Administrative Expense 85,000
Operating Income P12,800

8. Creating and Using a Cost Formula

Why: The purpose is to provide managers with a quantitative estimate of both total fixed
costs and the variable cost per unit of the cost driver(s). After these cost formula
components are determined, managers can predict total costs at various levels of output.

Information:
The art and graphics department of State College decided to equip each faculty office
with an inject color printer (computers were already in place). Sufficient color printers had
monthly depreciation of P250. The department purchased paper in boxes of 10,000 sheets
(20 reams of 500 sheets each) for P35 per box. In cartridges cost P30 and will print, on
average, 300 pages.

Required:
a. Create a formula for the monthly cost of inject printing in the department.
b. If the department expects to print 4,400 pages next month, what is expected total fixed
cost? Total variable cost? Total printing cost?
 Cost Accounting and Control 33

Solution:

a. The cost formula takes the following form:

Y = a + bX
The monthly fixed cost is P250 (the cost of printer depreciation), as it does not vary
according to the number of pages printed. The variable costs are paper and ink, as both
vary with the number of pages printed

Cost of paper per page is P35/10,000 = P0.0035

Cost of in per page is P30/300 = P0.10
Variable rate per page is P0.0035 + P0.10 = P0.1035
The cost formula is:
Total Cost of Printing = P250 + (P0.1035 x Number of pages)

b. Expected fixed cost for next month is P250

Expected variable cost for next month is P0.1035 x 4,400 pages = P455.40
Expected total printing cost for the next month is P250 + P455.40 = P705.40

9. High-Low Method Example 1

Why: The high-low method provides managers with a quick way of estimating cost
behaviour. Only two data points are needed (high and low activity/driver points). This
method is relatively easy and inexpensive for companies to conduct.

Information:
Blue makes blue jeans. The company controller wants to calculate the fixed and
variable costs associated with electricity used in the factory. Data for the past eight months
were collected:

Month Electricity Cost Machine Hours

January P3,255 460
February 3,485 500
March 4,100 600
April 3,300 470
May 3,312 470
June 2,575 350
July 3,910 570
August 4,200 590

Required: Using the high-low method, calculate the fixed cost of electricity, calculate the
variable rate per machine hour, and construct the cost formula for total electricity cost.
 Cost Accounting and Control 34

Solution:

Step 1: Find the high and low points

The high number of machine hours is in March, and the low number of machine
hours is in June. (Hint: Did you notice that the high cost of P4,200 was for August? Yet
August is not the high point because its number of machine hours is not the highest activity
level. Remember, the high point is associated with the highest activity level; the low point is
associated with the lowest activity level.

Step 2: Calculate the variable rate

Variable Cost rate or per unit = Cost at highest activity – Cost at lowest activity
Highest activity – Lowest activity
Variable rate = (P4,100 – P2,575)/(600-350) = P1,525/250
= P6.10 per machine hour

Step 3: Calculate the fixed cost.

Let’s choose the high point with cost of P4,100 and machine hours of 600.

Fixed Cost=Total Cost at highest activity – [Variable Cost per unit x Highest activity in units]

Fixed Cost = P4,100 – (P6.10 x 600) = P4,100 – P3,660 = P440

You can check your work by computing fixed cost using the low point. You should
get the same answer.
Step 4: Construct a cost formula: If the variable rate is P6.10 per machine hour and fixed
cost is P440 per month, then the formula for monthly electricity cost is:
Total Electricity Cost = P440 + (P6.10 x Machine Hours)

10. High-Low Method Example 2

Information: Data for the past 10 months were collected for Kristal, Inc. to estimate the
variable and fixed manufacturing overhead. The following data on supplies cost and direct
labor hours from January to October are available.

X Y
Direct Labor Hours Supplies Cost
20 P50
40 110
60 150
20 70
30 80
40 100
50 150
19 60
30 110
 Cost Accounting and Control 35

50 120
Required: Determine the variable cost rate per hour and the fixed cost portion using
the high-low method.

Solution:

Variable cost rate per hour =P150-P60

60-10
= P90/50
= P1.80

Fixed Cost:

High point: @ 60 hour level

FC = P150 – (P1.80 x 60)
= P150 – P108
= P42

Low point: @ 10 hour level

FC = P60 – (P1.80 x 10)
= P60 – P18
= P42