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Chapter Two
Cost concept and Cost classification
2.1 Cost and Cost Terminology
Definition
Cost:- is a measure of the acquisition or consumption of scarce or constrained resource to achieve a specific
objective.
Cost accounting:-is a process that identifies, defines, measures, reports and analysis the various elements of
direct and indirect cost associated with manufacturing and marketing goods and service.
It identifies and defines cost data.
It measures the information.
The unit of measurement used is monetary unit.
Information which is not measured in monetary unit is out of the domain of cost accounting.
Cost accounting will not identify and measure cost data for the sake of cost measurement only. I t analyzes
and reports the information to the users
Cost plays a significant role in managerial function that in planning, executing and controlling.
Cost data are essential in preparation of Income Statement and also valuation of inventories.
A Feature of costs
1. Cost measures the use of resources such as material, labor etc.
2. Cost measurements are expressed in monetary terms.
Cost tries to measure: the use of labor hours, material, machine hour &
inputs in terms of monetary units
3. Cost measurements always relate to purpose or activity which is cost object,
without which no purpose is served.
- A costing system typically accounts for cost in the basic stages:-
 cost accumulation &
 cost Assignment
 Cost accumulation:- is the collection of cost data in some organized Way by means of an accounting
system.
Beyond accumulating costs, managers assign costs to designated cost objects to help decision making.
Cost object is defined as any activity for which a separate measurement of cost is desired.
 Cost Assignment:- is a general term that encompasses both:-
1. Tracing accumulated cost to a cost object &
2. Allocating accumulated cost to a cost object.

Cost tracing and cost allocation

Cost Tracing:- is used to describe the assignment of direct cost to the particular cost object and can be
traced to it in an economical feasible way
Cost Allocation:- is used to describe the assignments of indirect cost to the particular cost object but cannot be
traced to it in an economically feasible way

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B The concepts of cost and Expense

Accountants have defined cost as “An Exchanged price, a forgoing, a sacrifice’’ made to secure benefits.
 Frequently the term “cost “ is used synonymously with term “Expense”
 however An Expense is measured by the amount of decrease in asset or Increase liabilities related to
production $ delivery of good & the Rendering of service
 Expense in its broadest sense includes all Expired costs which are deductible from revenue.
2.2. Classification of costs
 Cost is classified based on their relationship to final products, behavior, for financials presentation purpose
or timing controllability or other related factors.
These classifications are Explained in the following manner:-
2.2.1 Relationship of the costs to the product
 Cost in relationship of product classified as: a. Material cost
b. Labor cost

c. Factory overhead cost

A Material costs
These are principal substances used in production that are traced In to finished goods by the addition of
Direct Labor & factory overhead.
The cost of material may be divided into direct and indirect material cost
 Direct material cost: - are materials that can be identified with the Production of finished goods & that
represents major material cost of producing that product. E.g. Leather in shoe factory Wood in Furniture
Company.
 Indirect material cost :-
 All material that are involved in the production process of a product that are not direct material are
considered as indirect material
E.g. lubricating oils, cleaning materials $ supplies.

B labor cost:- is the cost of physical & mental effort expended in the Production of a product.
- Labor cost are classified into :- direct & indirect labor cost
 Direct labor cost:-All labor directly involved in the production of finished goods that can be easily traced to
the products. Expense Wage for machine operators, assembler, painter. etc.
 Indirect labor cost:- All labors involvement outside the direct labor is indirect labor. Indirect labor costs
are included as part of factory overhead
Example:- supervisors ,salary, cleaner’s salary etc.
C Factory overhead cost (FOH)
This all inclusive cost pool is used to accumulate the indirect labor, indirect material & all other indirect
manufacturing cost which can’t be directly identified with specific products.
2.2.2. Relationship of the costs to the production
 The cost categories on the basis of their relationship to production are prime costs and conversion costs
(processing costs).
a. Prime costs: Is direct material cost & direct labor cost which are directly related to production.

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Formula:- PC = DM+DL

b. Conversion cost: concerned with transforming direct material in to finished products, that cost
associated with DL & MOH.

Formula:- CC = DL+MOH

Therefore:- Total Manufacturing cost = prime cost +conversion cost or

Total manufacturing cost = DM+DL+MOH

2.2.3. Relationship of costs to the volume of production

 Cost can be classified as variable, fixed or mixed costs base on how costs behave with respect to volume
of production. ]
a. Variable cost: the total costs change in direct proportion to changes in volume of outputs within the
relevant ranges, while the unit cost remains constant.
b. Fixed cost: the total cost remains constant over relevant range of out puts, whereas the fixed cost per
unit varies without puts.
- It do not vary with volume of activity in total
- It became progressively smaller on a per unit basis as volume increase.
c. Mixed costs: - these contain both fixed & variable characteristics.
- It is not possible to classify all costs as purely variable and purely fixed.
Graphical Representation of variable fixed & mixed cost
a. If graphically depicted, the variable cost per unit becomes the slope of the graph. Example
TVC
TC

0 No of unit produced(Volume)
b. When the total fixed cost is depicted on a graph, the slop is zero
TC

TVC

0 Volume of activity.

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c. The following graph illustrates mixed cost.

TC

VC

FC

Volume of output.
 Total cost:- is simply the sum of variable cost and fixed cost
 The total cost can be expressed in an equation form.
Y= AX +B where
Y = Total cost
A = Variable cost per unit of volume.
B = Total fixed cost
X = total volume of activity.
AX = Total variable cost.
Cost Drivers
 A cost driver is characteristics of inactivity or event that cause that activity or event to incur cost.
 The cost driver of variable cost is the level of activity or volume whose change causes the Variable Cost
to change proportionately.
 Costs that are fixed in the short run have no cost driver in the short run but may have a cost driver in the
long run.
Relevant Range
 A Relevant Range is the level of activity or volume in which a specify relationship b/n the level of
activity or volume & the cost in question is valid.
Example
- Fixed cost is fixed only in relation to a given range of the total activity or volume & for a given time
span.
- Fixed cost remains constant up to maximum level of activity & for the budget period.
Example
1. You are given the following data of ABC manufacturing company on Dec. 31, 2005.
 Quantity produced 10 unit, 30 unit, 40 units, 50 units
 Total fixed cost Ps Br. 1,000
 The variable cost per unit of out is birr 2
Required
a. Calculate the total cost of production for all units given.
b. Prepare a graph that shows the total cost of production for the given level of outputs.

Solution

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a. Total cost = TVC +TFC

At Qty = 10 unit, TC = 2x10 +1000 = 1020
At Qty = 30 unit, TC = 2x30 + 1000 = 1060
At Qty = 40 unit, TC = 2x40 + 1000 = 1080
At Qty = 50 unit, TC = 2x50 + 1000 = 1100

Solution question
TC
1100
1080

1060

1020

1000 TFC

Qty
10 30 40 50

2.2.4 Cost classification based on the responsibility center

In manufacturing organization there two basic departments
The two departments are identified as production & service department
 Production department
These are responsibility centers where operations are performed to produce product.
The costs incurred by such departments are charged to the product.
Cost incurred in the production departments is called production department cost. Example: - assembly
cutting, mixing, finishing, packing department etc.
 Service department
These departments will support the production department but does not directly engage in production.
It cost are a part of the total FOH & must be insured in the cost of product. Example: main tenancies,
information processing data, payroll department, food Cost incurred in the production departments is called
production department cost.
2.2.5. Cost classification by functional Areas
These types of grouping and analysis help management in preparing budget & Financial Statement.
The following are some costs grouped by functions for a manufacturing enterprise
a. Manufacturing cost:- all costs incurred to produce finished goods.
- These are the sum of DM cost, DL cost & cost & MOH costs.
b. Marketing & distribution costs: all costs incurred in order to sell a product or service.
- Costs included are cost of processing orders, cost of getting customer, cost of retaining customer,
cost of transportation etc.

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c. Administrative & general expense

These costs are incurred to direct, control & operate the company
d. Financing cost: - these are costs incurred in relation to obtaining & operating funds for the company.
- Usually they include cost of borrowing(interest expense)
e. Research & development costs
- Include all costs of developing new proto types of new products and testing new products are all
classified a research & development cost.
2.2.6. Cost classification by period change to revenue.

 Cost may be classified on the basis of time period they are charged organist revenue.
 The management uses these types of classification to properly much expense & revenues of the
period.
 This is essential for the preparation of financial statements
 There costs can be grouped into two: - a. produce cost.
b. period cost.
a.
Product cost:- these cost are initially inventories & when goes are sold they are charged to cost of
goods sold.
- This helps us to compute the gross profit for the period.
 Product costs are composed of three elements in the case manufacturing firms! DM, DL and
FOH.
 The cost are treated as assets units the product is sold.
 For merchandising sector companies, product cost are the cost of purchasing the goods that are
resold in the same form including freight cost.
 For service enterprise: there are not inventor able cost
b. Period cost:- costs these are associated with the passage of time rather than with the product.
 All operating expense are grouped as period costs
 Period cost is all cost in the income statement is other than Cost of goods sold.
 These cost are treated as expense of the period in which they are incurred b/c they are assumed not
to benefit for future period.
 Manufacturing enterprise, period costs include all non-manufacturing costs.
Examples:- selling and distribution expense
- Administrative expense
- Financing expenses &
- Research & development expense etc.
 Merchandising enterprise:- including all costs not related to the cost of goods purchased for resale in
the same form.
Example:- labor cost of sales, floor personnel & marketing cost
 For service sector:- there are no inventor able costs, all their cost are period costs.
2.2.6 Cost in relation to decision action or evaluation

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For economic decision making purpose, costs can be grouped into the following categories:-

Opportunity cost

Sunk Costs
Differential cost
Marginal cost & Average costs.
 Opportunity cost:- is an amount of revenue or other benefit that will be missed or cost if a particular
alternative is chosen.
 Sunk Cost:- such costs are past or historical costs.
 The cost which have been created by a decision that was made in the past that cannot be changed by
any decision that will be made in the future. E.g. investment in plant, machinery, building etc.
 They are not relevant for decision – making.
 Differential cost
- The difference in total cost b/n two alternatives is known as differential cost.
 In case the choice of an alternative results in an increase in total cost such increased cost are known
as incremental costs.
 Marginal costs and Average costs
- Marginal cost refers to increase or decrease in the amount of cost an account of increase or
decrease of production by a single unit.
- Average cost per unit is the total cost for whatever quantity is manufactured

2.2.7. Controllable and uncontrollable costs.

 Controllable Costs:-
- If a manager can control or heavily influence the level of cost then that cost is classified as a
controllable cost of that manager.
 Uncontrollable Cost.
- Cost that a manager cannot influence significantly are classified as uncontrollable cost that manager
2.3 Work flow of manufacturing Firm
 The steps and the charging of costs in accordance with thee flows of work in a typical cycle of operations
of a manufacturing firm that makes & sells its own products are outlined below:-
1. Procurement: - It is the process of obtaining something.
- Purchase of materials, labor & OH are recorded as debit to RMs, factory payroll and Manufacturing
overhead control.
- As these costs are used, or applied in factory operations, they are created to these account &
transferred to production.
2. Production: - cost of material, labor & overhead transferred into production are debited to Work in
Process.
 As goods are finished, their total cost is removed from the WIP account by credit entry & charged
(Debited) to cost of goods

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3. Warehousing: - The cost of finished goods transferred form WIP is recorded as a debit to finished
goods.
 The cost of goods shopped from the mare house to customer is credited to finished goods &
charged(Debited) to cost of goods sold
4. Selling: - as finished goods are sold & shipped from the ware house, their cost is debited to the cost of
goods sold.
- At the end of the acct period, this account is closed by crediting cost of goods sold & Debiting
income summary account.

2.3.1 Flow of physical goods in production

Warehouse
Direct materials Direct Manufacturing Finished
purchased materials used firm goods
5.

DL MOH

 This model (diagram) applies as much to a process costing system at it does to job order costing
system.

2.3.2 Types of inventory

Inventories of manufacturing business: They purchase material and components and convert them into
different finished goods.

They typically have one or more of the following three types of inventories.

1. Raw material inventory

This refers to all materials purchased to be used in the production process. The cost material is composed of:

 The invoice price of the material

 The transportation cost of the material
 The insurance in transit cost of the material
 Loading and unloading costs
 All other costs incurred on the raw material to make ready for consumption
2. Work in process Inventory

Raw material is not accumulated for accumulation purposes. They must go to production process and be
processed into finished goods. When materials to out of to store, their value is no more reported as Raw
materials inventory account

They will go to the work- in- process Inventory account.

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The cost of work in process inventory is composed of:

 The cost of raw material changed to production

 The cost of labor incurred on items in process, and
 The manufacturing overhead cost
3. Finished Goods Inventory
When the manufacturing process is completed, finished product will be sent to where house so that they will
be available for selling. There for the cost accumulated in the work in process inventory account must be
transferred to finished goods but not sold to customer. The cost is composed of:

 Applicable cost of raw materials

 Applicable cost of labor and
 Applicable cost of manufacturing overheads

B) Merchandising: - sector companies: they purchase and then sell tangible products without changing their
basic form. They hold only one type of inventory, which is the product in its original purchased form.
C) Service sector companies: Service sector companies provide only services or tangible products to their
customers and hence do not hold inventories of tangible products for sale.
2.3.3. Financial Statements for Manufacturing Enterprises:
The financial statements for manufacturing enterprises are more complex than those for service and
merchandising enterprises.
Manufacturing organization: In the case of manufacturing organization, manufacturing costs are accumulated
to determine the cost of goods manufactured for completed goods and for partially completed goods.
The cost of goods manufactured can be divided into two portions – the sold portion called cost of goods sold
and the portion remaining is called finished goods inventory.

 Some important formulas to compute manufacturing costs

1. Cost of direct Cost of beginning Cost of purchase Cost of ending
Materials used = direct materials + direct materials - direct materials
inventor inventory

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2. Cost of Goods Cost of beginning Manufacturing Cost of ending

Manufactured = work in process + costs incurred in - work in process
inventor current period inventory

3. Cost of Goods Beginning finished Cost of goods Ending Finished

Sold = goods inventor + Manufactured goods inventory
-
Exercise
1. Addis – Ice inc. had $52,000 of inventory in direct materials inventory on January 1,2005,
During the year, Addis – ice purchased $586,000 of additional direct materials. At December
31,2005,$78,000 of the direct materials were still on hand. How much direct materials are
placed to production during 2005?
2. In question number 1 above, in addition to the direct materials, Addis – ice Incurred $306,000
of the direct labor cost during 2005. Manufacturing overhead for 2005 was $ 724,00. Addis –
Ice started 2005 with $132,000 in work process. During 2005, units costing $1,480,000 were
transferred to the finished goods inventory. What is the ending balance in work in process at
December 31,2005?

Exercise 2

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1. You are asked to prepare financial statement of small manufacturing firm for a fiscal period. The financial
statement is needed as part of the firm’s application for a line of credit. The necessary accounting data are
not maintained properly, however, you found the following incomplete information.
Finished goods inventory, beginning ……………………………………… birr 4,000
Work in process inventory, beginning …………………………………… 3,400
Raw materials inventory, beginning ……………………………………… 3,100
Sales for the period………………………………….. 95,000
Direct labor cost …………………………………….. 35,000
The following estimated data were also available:
Factor overhead cost average 30% of conversion cost
Materials purchase for the period amounts birr 24, 000
Prime costs average 80% of cost of goods manufactured.
Gross profit on sales averages 25%
Cost of goods available for sales amounts 80,000
Selling and distribution costs are birr 11,230
General administrative expenses are birr 9,500
Required: birr
i. compute the ending inventory of
a. Raw materials
b. Work in process
c. Finished goods
ii. Prepare
a. Cost of goods manufactured statement
b. Functional income statement
List and describe the three types of inventories in manufacturing firm.

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