Chapter III
COST CONCEPTS AND CLASSIFICATIONS
ANGELINE A. LOGATIMAN
AM 113_MANAGERIAL ACCOUNTING MARVIN M. SUMAYA
2nd semester; AY 2024-2025 IVAN L. DUJALI
Desired Learning Outcomes
Explain the basic concept of “cost.”
Explain the process of cost allocation.
Understand how material, labor, and overhead costs
are added to a product at each stage of the production
process.
Define basic cost behaviors, including fixed, variable,
semi variable, and step costs.
Identify the components of a product and
manufacturing costs.
Explain how costs are presented in financial
statements.
CONCEPTS OF COST
a foregoing, measured in monetary terms, incurred or
potentially to be incurred to achieve a specific objective"
(American Accounting Association).
It is a financial valuation of resources, materials, risks, time
and utilities consumed to purchase and produce goods and
services.
In Cost Principle of GAAP, assets should be recorded and
valued at the price for which they were bought instead of the
price at which they can be sold now.
Cost accounting is a managerial accounting process that
involves recording, analyzing, and reporting a company's
costs. Cost accounting is an internal process used only by a
company to identify ways to reduce spending.
The concept of cost, expense and loss are often used
interchangeably. These terms are defined by AICPA in
accounting terminology in the following:
Cost is “The amount, measured in money, of cash
expended or other property transferred, capital stock
issued, services performed, or a liability incurred, in
consideration of goods or services received or to be
received.
Expense is “all expired costs which are deductible
from revenues.” Revenue is defined as the price of
goods sold and services rendered. In a narrower
sense “the term “expense’ refers to operating, selling,
or administrative expense, interest, and taxes.” Items
included in cost of manufacturing, such as materials,
labor, and overhead, should be described as costs,
not expenses.
Loss is “
(1) The excess of all expenses, in the broad sense
of that word, over revenues for a period, or
(2) the excess of all or the appropriate portion of the
cost of assets over related proceeds, if any,
when the items are sold, abandoned, or either
wholly or partially destroyed by casualty or
otherwise written off. When losses such as
described in (2) are deducted from revenues.
Classification of costs is necessary in order to
determine the most suitable method of accumulating
and allocating cost data.
Cost classification is a systematic approach to
categorizing expenses incurred by any business.
This classification aids in financial management,
budgeting and decision-making by providing clarity on
different types of cost.
Costs can be classified into different categories for
different purposes. Costs may be categorized
according to their nature, management function,
traceability, timing of charge against revenues,
behavior, timing, and relevance to decision-
making.
A. Classification by Nature
Material Costs: Expenses related to raw
materials and components used in production.
Examples: Raw materials, packaging costs.
Labor Costs: Wages and salaries paid to
employees involved in production. Includes both
permanent and temporary workers.
Other Expenses: Miscellaneous costs
associated with manufacturing and selling.
Examples: Utilities, administrative expenses.
B. By Function:
Manufacturing . Cost applied to producing a
product
Marketing. Cost incurred in selling a product or
service.
Administrative. Cost incurred in policy-making
activities
Financial. Costs related to financial activities.
C. By Traceability of a Product
Direct Cost - which are charged directly to the
product or easily traceable to a specific product
or service. Ex. Direct materials and labor.
Indirect Costs -- which must be allocated and
not directly traceable to a single product’ often
shared among multiple products of
departments. Ex. Factory overhead,
administrative salaries
D. By Department:
Production - a unit in which operations are
performed on the part or product.
Service - a unit not directly engaged in
production and whose costs are ultimately
allocated to a production unit.
E. By Relation to Volume and Behavior
Variable costs - vary in total in proportion to changes in
activity. Examples include direct materials, direct labor, and
sales commission based on sales.
Fixed costs - costs that remain constant regardless of the
level of activity. Examples include rent, insurance, and
depreciation using the straight line method.
Mixed costs - costs that vary in total but not in
proportion to changes in activity. It basically includes a fixed
cost potion plus additional variable costs. An example would
be electricity expense that consists of a fixed amount plus
variable charges based on usage. (Semi-Variable).
Step Costs – costs that do not change in direct proportion to
increasing levels of activity. It is constant on a certain
activity level but increase or decrease when an activity
threshold is met. Example cost of a new equipment, Lush
and fertile land. (Semi-Fixed).
F. Classification by Timing
Product Costs: Costs that are capitalized as
inventory until sold. Includes direct materials,
direct labor, and manufacturing overhead.
These are directly deducted to the revenue.
Period Costs: Expensed in the period they are
incurred and not tied to production levels.
Examples: Selling and administrative expenses.
These are deducted in the gross profit.
G. According to Relevance to Decision Making
Relevant cost - cost that will differ under alternative courses of
action. In other words, these costs refer to those that will affect a
decision.
Standard cost - predetermined cost based on some reasonable
basis such as past experiences, budgeted amounts, industry
standards, etc. The actual costs incurred are compared to
standard costs.
Opportunity cost - benefit forgone or given up when an
alternative is chosen over the other/s. Example: If a business
chooses to use its building for production rather than rent it out to
tenants, the opportunity cost would be the rent income that would
be earned had the business chose to rent out.
Sunk costs - historical costs that will not make any difference in
making a decision. Unlike relevant costs, they do not have an
impact on the matter at hand.
Controllable costs - refer to costs that can be influenced or
controlled by the manager. Segment managers should be
evaluated based on costs that they can control.
Elements of Costs
A cost element is the cost of a resource that is consumed by an
activity. The concept is used in activity-based costing.
Three Elements of Manufacturing Costs:
1. Direct material Cost. The acquisition cost of all materials that
are identified as a part of the finished goods and may be traced
to the finished goods in an economically feasible manner.
2. Direct labor cost. The wages of all labor that can be identified
in an economically feasible manner with the production of
finished goods. Ex. Labors of machine operators or assemblers.
Other labor that are not traceable are considered indirect labor.
Ex. Wages of janitor and guard, etc.
3. Indirect manufacturing cost or Factory Overhead Cost. All
cost other than direct materials and direct labor that are
associated with the manufacturing process. Other terms
describing this cost are factory overhead cost, factory burden,
manufacturing overhead and manufacturing expenses.
There are two types of factory overhead cost:
a. Variable factory overhead cost . Examples are power,
supplies, and most indirect labor.
b. Fixed factory overhead cost. Examples are rent,
insurance, property taxes, depreciation, and supervisory
salaries.
Two of the three elements are sometimes
combined:
Prime Costs - is consist of Direct materials
plus direct labor cost “necessary” to produce
finished product.
Conversion cost - consist of Direct labor plus
factory overhead cost ( variable and fixed) TO
“CONVERT” direct materials into finished
product.
TOTAL COST and UNIT COST
Total Cost. The cumulative cost for the established category.
Unit Cost. The total cost divided by the number of units of
activity or volume.
Conclusion!!!
Understanding the various
classifications of costs is essential for
effective financial management within
an organization. Each classification
serves a distinct purpose, aiding in
budgeting, cost control, and strategic
decision-making.
Thank you for
listening!!!
