Chapter es vale escent ited a ae COSTS - CONCEPTS AND CLASSIFICATIONS LEARNING OBJECTIVES Upon completion of this chapter, you should be able to * Distinguish between cost, expenses, and losses. Distinguish between direct arid indirect costs, Define the three integral components of a product. Define prime costs and conversion costs. Define variable, fixed, and mixed costs and discuss the effects of changes in volume on these costs. Distinguish between common costs and joint costs Distinguish between capital expenditures and revenue expenditures * Identify the costs for planning, control and analytical processes eoee ee Costs are associated with all types of organizations — business, non-business, service, retail, and manufacturing. Generally, the kinds of costs’ that are incurred and the way in which these costs are classified will depend on the type of organization involved. Our‘ initial focus will be on a manufacturing, but in our discussion we should be aware that, in a conceptual sense, manufacturing encompasses much more than just firms in the industrial sector of our economy. It also encompasses many organizations that are typically viewed as being service in nature, such as movie studios and fast-food outlets. Organizations such as these are involved in “manufacturing in the sense that they create a distinct product for customers or patrons. As we proceed with our discussion, therefore, we should keep in mind that manufacturing is a broad term, and that the costs included under the manufacturing heading have application to a wide range of organizations — many of which may be involved in service-type activities. An understanding of the cost structure of a manufacturing company therefore provides a broad, general understanding of an be very helpful in understanding the cost structures of other types of 1920 Cost Accounting Before cost terminology can be discussed the term cost itself must 7 deca font is the cash or cash equivalent value sacrificed for goods, ane n. We say cash expected to bring a current or future benefit to the organizat en iced ponds ‘quivalent because non-cash assets can be exchanged for the pa Sood ae services. For example, it may be possible to exchange land for som equipment, Costs are incurred to produce future benefits in a profit making firm, future benefits usually mean revenue. As costs are used up in the production of revenues, they are said to expire.( Expired costs are called expenses: In each period, expenses are deducted from revenues in the income statement to determine the period’s profit. -A.loss is a cost that expires without producing any revenue benefit. The focus of cost accounting is on costs, not expenses. CLASSIFICATION OF COSTS L. Costs classified as to relation toa product A. Manufacturing costs/product costs 1. Direct materials 2. Direct labor. 3. Factory overhead B. Non-manufacturing costs/period costs 1. Marketing or selling expense 2. General or administrative expense IL Costs classified as to variability A. Variable costs B. Fixed costs C. Mixed costs TEL. Costs classified as to relation to manufacturing departments A. Direct departmental charges B. Indirect departmental charges TV. Costs classified to their nature as common or joint A. Common costs B. Joint cost uel © @ coyChapter 2 — Cost Concepts and Classifications 21 V. Costs classified as to Telation to an accounting period A. Capital expenditures B. Revenue expenditures I. Costs for Planning, control, and analytical processes A. Standard costs B. Opportunity costs C. Differential cost D. Relevant cost E. Out-of-pocket cost F. Sunk cost G. Controllable cost MANUFACTURING COSTS/PRODUCT COSTS/ANVENTORIABLE COSTS Direct materials Direct materials are the basic ingredients that are transformed into finished products through the use of labor and factory overhead in the production process. Direct materials are those that can be traced to the finished product can they form part of the product. All manufactured products are made from basic direct materials. The basic material may be iron ore for steel, sheet steel for automobiles, flour for bread wood tables and chairs,. Theses examples show the link between a basic raw material and a final product. The way a company buys, stores, and uses materials is important Timely purchasing is important because if the company runs out of materials, the manufacturing process will be forced to shut down. Shutting down production results in no products, unhappy customers, and loss of sales and profits. Buying too many direct materials, on the other hand, can lead to high storage costs. Proper storage of materials will avoid waste and spoilage. Large enough storage space and orderly storage procedures are esséntial. Materials must be handled and stored properly to guarantee their satisfactory use in production. Proper records, the materials stockcars, make it possible to find goods easily. Such records reduce problems caused by lost or misplaced items.22 Cost Accounting Direct materials are materials that become part of a finished ee Seis Conveniently and economically traced to specific product units. The co: materials are direct costs. In some cases, however, even though a material ae Part of a finished product, the expense of actually tracing the cost of a speci ic material is too great, Some examples of this include nails in furniture, bolts in automobiles, and rivets in airplanes, These minor materials and other production Supplies that cannot be conveniently or economically traced to specific products are accounted for as indirect materials, Indireot materials costs are part of factory overhead costs, ot Direct labor Direct labor represent the amount paid as wages to those working directly on the product. .Labor services are, in essence, purchased from employees working in the factory. In addition, other types of labor are purchased from people and organizations outside the company. The labor costs usually associated with manufacturing include machine operators; maintenance workers; managers and Supervisors; support personnel; and people who handle, inspect, and store materials, Because these people are all connected in some way with the production process, their wages and salaries must be accounted for as production costs and, finally, as costs of products. However, tracing many of these costs directly to individual products is difficult. To help overcome this problem, the wages of machine operators and other workers involved in actually shaping the product are classified as direct labor costs. Direct labor costs include all labor costs for specific work performed on products that can be conveniently and economically traced to end products, Labor costs for production related activities that cannot be conveniently and economically traced to end products are called indirect labor costs. These costs include the wages and . Salaries of such workers as machine helpers, supervisors, and other Support personnel. Like indirect materials costs, indirect labor costs are accounted for as factory overhead costs. Payroll related costs, such as payroll taxes, group insurance, sick pay, vacation and holiday pay, and other fringe benefits can be considered as part of direct labor costs, but are usually included as factory overhead. prime costs, while direct labor plus factory costs and conversion costs may be diagrammed Direct labor plus direct materials = overhead = conversion costs. Prime as shown on the next page Total manufacturing cost = direct materials, + direct labor + factory overheadChapter 2 Cost— Concepts and Classification 23 Prime Costs Direct Direct Factory Materials Labor Overhead Conversion Costs Factory Overhead The third manufacturing cost element is a catchall for manufacturing costs that cannot be classified as direct materials or direct labor costs. Factory overhead costs are a varied collection of production-related costs that cannot be practically or conveniently traced directly to end products. This collection of costs is also called manufacturing overhead, factory burden, and indirect manufacturing costs. Examples of the major classifications of factory overhead costs are: Indirect materials and supplies: nails, rivets, lubricants, and small tools. Indirect labor costs: lift-truck driver’s wages, maintenance and inspection labor, engineering labor, machine helpers, and supervisors. Other indirect factory costs: building maintenance, machinery and tool maintenance, property taxes, property insurance, pension costs, depreciation on plant and equipment, rent expense, and utility expense. NON-MANUFACTURING Cc 'S/PERIOD COSTS Marketing or selling expenses Marketing or selling expenses include all costs necessary to secure customer orders and get the finished product or,service into the hands of the customer. Since marketing expenses relate to contacting customers and providing for their needs, these expenses are often referred to as order-getting and order-filling costs. Examples of marketing expenses include advertising, shipping, sales travel; sales commissions, sales salaries, and expenses associated with finished goods warehouses, All organizations have marketing costs, regardless of whether the organizations are manufacturing, merchandising, or service in nature,24 Cost Accounting Administrative or general expenses sate i Administrative expenses ‘iicieie all executive, organizational, and ke expenses that cannot logically be included under either production or marketing, Examples of such expenses include executive compensation, general accounting, secretarial, public telations, and similar expenses having to do with the overall, general administration of the organization as a whole. As with marketing expenses, all organizations have administrative expenses COSTS CLASSIFIED AS TO VARIABILITY Fixed, Variable, and mixed One of the most important cost classifications involves the way a cost changes in relation to:changes in the activity of the organization. Activity refers to a measure of the organization's output of products or services. In specifying cost behavior, the managerial accountant often limits the description to.a specific range of activity. This is called the relevant range. Fixed cost Items of cost which remain constant in total, irrespective of the volume of production. Fixed cost are not related to activity within the relevant range. If activity increases or decreases by 20 percent, total fixed cost remains the same. Cost per unit decreases as volume increases, and increases as volume decreases. Fixed costs are assignable to departments based on difference allocation methods. Examples are salaries of production executives, depreciation of equipment computed on a straight-line basis, periodic rent payments, and insurance, Fixed costs may classified into two categoriex, de pending on the ability of management to influence the levels of these costs in the short-term, 1) Committed fixed costs — costs that commitments on the part of management Example ~ depreciation on equipment, Tepresent relatively long term it as a result of a past decision. 2) Managed fixed costs (also known as discretionary, Programmed, or planned fixed costs) ~ costs that are incurred on a short-term basis and can be more easily modified in response to changes in management objectives. Examples — advertising, research and development and costs of. training of employeesChapter 2 Cost— Concepts and Classification 25 Sioen oa below is a graph of fixed cost. It is clearly shown that total fixed cost oye langed as activity changes, When activity triples, from 10 to 30 units, ixed cost remains constant at P1,500. If activity level is only 1 unit, then the fixed Cost per unit is P1,500. If the activity level is 10 units, then the fixed cost per unit declines to P150 per unit. So we can conclude that fixed cost per unit will decrease as we increase the volume or units of production and fixed cost per unit will increase as we decrease the volume of production. Total fixed cost 1,500 I | | 10 20 30 Activity Graph of total fixed cost Activity 3 Fixed cost per unit Total Fixed Cost 1 P 1,500 1,500 2 750 1,500 5 300 1,500 10 _ 150 1,500 20. 75 1,500 30 50 1,500 Variable costs These are the items of cost which vary directly, in total, in relation to volume of production. If activity increases by 20 percent, total variable cost increases by 20 percent also. Cost per unit remains constant as volume changes within a relevant range. Examples.are: direct materials, direct labor, royalties, and commission of salesmen, Shown on the next page is a graph of total variable cost. As this graph shows total variable cost increases proportionately with activity. When activity doubles from 10 to 20 units, total variable cost doubles, from P1, 000 to P2, 000. However, the variablecost per unit remains the same as activity changes. The26 Cost Accounting variable cost associated with each unit of activity is P100, whether it is the first unit, the fourth, or the tenth. i: i it decre: To summarize, as activity changes, total variable cost increases ee ene ases Proportionately with the activity change, but unit variable cost remains . Total Variable Cost 3,000 2,000 1.000 Activity 10 20 30 Graph of total variable cost TABULATION OF VARIABLE COST. Acti Variable Cost per Unit Total Variable Cost 1 P 100 P 100 10 100 1,000 20 100 2000 30 100 3,000 Mixed cost : Items of cost with fixed and variable components. Mixed costs vary with the level of production, though not in direct relation to it, probably because Part of the cost is fixed while the rest is variable. TWo types of mixed costs exist — semivariable costs and step costs Semivariable cost. The fixed portion of a semi-variable cost usually represents a minimum fee for making a particular item or service available. The variable portion is the cost charged for actually using the service. The cost of. electricity where there is a basic minimum charge plus a specified cost per kilowatt hour above theChapter 2. Cost — Concepts and Classification 27 minimum is an example of such a semi-variable cost. The cost charged for using a iable cost.. The cost of the cell phone under a plan is also an example of a somi-vari plan is fixed and it is for a specified time used, however if the user exceeds the time allowed, then charges will be made on a per minute basis. Semi-variable cost mi-variable costs 35,000 30,000 Variable 25,000 (P°15,000) 20,000 15,000 10,000 Fixed 5,000 20,000) 0 1,000 5,000 KILOMETERS at a flat rate of P 20,000 per month Assume that a company rents a delivery truck plus P 1.50/km.driven. The fixed portion is the P20,000 monthly rental fee; the If 10,000 km. are driven during the month, variable portion is the P1.50/km driven. the total monthly cost of the delivery truck is P. 35,000, computed as follows: Flat fee (fixed portion) P 20,000 Variable portion - 10,000 km. x P 1.50 15,000 Total cost 235,000 Step costs - the fixed part of step costs changes abruptly at various activity levels because these costs are acquired in indivisible portions. A step cost is similar to a fixed cost within a very small relevant range. 180,000 150,000 rl | le 120,000 90,000 60,000 30,000 028 _ Cost Accounting The supervisor's salary is an example of step cost. Assume that oO a salary of P 30,000 is needed for every 10 workers, then if 15 wor ve used, still 2 supervisors (with salaries of P60,000) willbe needed. If 18 workers ate used, sil 2 supervisors would be needed. If the number of workers increases to 22, supervisors would be needed, {deally, for both planning purposes and for making certain types of decisions, all costs would be classified as either fixed or variable, with semi-variable costs | ing Separated inte-their-Gxed and-variable-co ani antares erin ier in estimating the variable and fixed components of a mixed cost is to a = cause and effect relationship between activities that affect costs,. There are if sa methods of separating mixed costs into fixed and variable components: (1) Scattergraph, (2) high-low point, (3) method of,least square. We will illustrate the use of high-low point method and method of least square (1) _HIGH-LOW POINT METHOD Summary of electricity costs and direct labor hours Month Direct labor hrs. Cost of electricity January 28 P 625 February 24 565 March 30 630 April 33 640 May 38 685 June 34 640 July 35 655 August 40 700 September 42 115 October 41 76 November 43 700 December 32 630 Directlaborhrs. Cost Highest month (Oct.) 47 P 726 Lowest month (Feb.) 24 565 Difference 2B P i6r ‘Wariable rate per direct labor hour = P_161 . 23 hours = P Tidirect labor hourChapter 2 Cost — Concepts and Classification 29 Fixed cost can be computed from either the high or low data. High Low Total cost of electricity P 726 P 565 Less: variable proportion 7x47) 329 (P 7x24) 168 Monthly fixed cost P__397, P3297 The formula for projecting the total monthly cost of electricity based on these data would be P 397 plus P7 multiplied by the direct-labor hours expected to be worked during the period ( ¥ = FC + VC or Y = FC + VX) where Y = Total cost VC = Total variable cost V = Variable cost per unit FC = Fixed cost X = Activity level (2) METHOD OF LEAST SQUARE The three formulas to be used in least-square method are: Equation 1 Y = atbx Equation 2 _zY = nat brXx Equation 3 EXY = Exa+bEx? Using the same data as in the high-low method the following have been computed DLHrs. Electricity Cost x. y XY. x 28 625 17,500 . 784 24 565 13,560 516 30 630 18,900 900 33 640 21120 1,089 38 685 26,030 14d4 34 640 21,760 1,156 35 655 22,925 1,225 40 700 28,000 1,600 42 15 30,030 1,764 47 726 34,122 2,209 43 700 30,100 1,849 — 830 20160 1,024 ze 426 7911 (284,207 15,62030 Cost Accounting By substitution: Equation 2 ty = nat+bx (7911 = 12a +b426) 35.5 (426/12) Equation 3 Exy =, Exa +bEx” 284,207 426a + b15,620 Equation2x35.5 280,840.5 = 426a + b15.123 3,366.5 0 b 497 b = 3,366.5/497 b = 6.77 Substituting the value for Equation 2, we can compute for a as follows 7,911 = 12a + (6.77)(426) 79M 12a + 2,884 12a = 7,911-2,884 : a = 5,027/12 = 418,92 Formula using high-low method Y=a + bx =397 +7x Formula using least square method Yea + bx = 419 +6.77x In most cases the amounts derived using high/low point and method of least square are not the same: Common cost vs. Joint cost _Common.cost Costs of facilities or services employed in two or more accounting periods, operations, commodities, or services. Just like indirect costs, these costs are subject to allocation. Example — if two departments are occupying the sam : ae i" ne buildi depreciation of the building id a common cost subject to allocation based se ee area occupied. .Chapter 2 Cost - Concepts and Classification 31 Joint cost ae of materials, labor, and overhead incurred in the manufacture of two or more products at the same time. A major difficulty inherent to joint costs is that they are indivisible and they are not specifically identifiable with any of the products being simultaneously produced. These costs are also subject to allocation, Example — direct materials, direct labor, and factory overhead cost incurred to manufacture two or more products up to the point of split-off (or where they will go separate ways) Capital expenditure vs, Revenue expenditure Capital expenditure Expenditure intended to benefit more than one accounting periods and is recorded as an asset. The allocation of the cost to the different periods is — depreciation for fixed tangible assets, amortization for intangible assets and depletion for wasting assets. Revenue expenditure Expenditure that will benefit current period only and is recorded as an expense. Direct vs. Indirect departmental charges Direct departmental charges Costs that are immediately charged to the particular manufacturing department(s) that incurred the costs since the costs can be conveniently identified or associated with the department(s) that benefited from said costs. Indirect departmental charges Costs that are originally charged to some other manufacturing department(s) or account(s) but are later allocated or transferred to another department(s) that indirectly benefited from said costs. Costs for Planning, control and analytical processes Standard costs : Predetermined costs for direct materials, direct labor, and factory overhead. They are established by using information accumulated from past experience and data secured from research studies. In essence, a standard cost is a budget for the production of one unit of product or service. It is the cost chosen by the managerial accountant to serve as the benchmark in the budgetary control system.32 Cost Accounting Opportunity cost The benefit given up when one alternative is chosen over another. Opportunity cos's are not usually recorded in the accounting system. However, opportu ty ss should be considered when evaluating alternatives for decision-making. 2h 0 can be used to perform only one function and cannot be sold or used in other ways, the opportunity cost of that asset is zero. Example 1 Michelle has a part-time job that pays her PL, 000 per week. She would like to spend a week in Boracay during summer vacation from school, but she has no vacation time available. If she takes the trip anyway, the P1, 000 in lest wages will be an opportunity cost of doing so. Example 2 Marco is employed with a company that pays him a salary of P20, 000 a month. He is thinking about leaving the company and returning to school. Since returning to school would require that he give up his P240, 000 salaries, the forgone salary would be an opportunity cost of seeking further education. Differential cost Cost that is present under one alternative but is absent in whole or in part under another alternative. An increase in cost from one alternative to another is known as incremental cost, while a decrease in cost is known as decremental cost. Differential cost is a broader term, encompassing both cost increases (incremental cost) and cost decreases (decremental costs) between alternatives. The accountant’s differential cost concept is basically the same as the economist’s marginal cost concept. In speaking of changes in cost and revenue, the economist employs the terms marginal cost and marginal revenue. The revenue that can be obtained from selling one more unit of product is called marginal revenue, and the cost involved in producing one more unit of product is calléd marginal cost. Differential costs can be either fixed or variable. To illustrate, assume that Avot Corp. is thinking about changing its marketing method from distrib retailers to distribution by direct sale, Present costs and revenues ar projected costs and revenues in the table on the next page. ution through ‘© compared toChapter 2 Cost — Concepts and Classification 33 Retailer Direct sale Differential Distribution | Distribution Cost and (present) (proposed) ‘Revenues: Revenues (V) P_ 900,000 P1.200.000 | P 300,000 Cost of goods sold (V) 50,000 600,000 150,000 ‘Advertising (F) 80,000 45,000 | ( 35,000) ‘Commission (V) 7 40,000 40,000 Warehouse depreciation (F) 50,000 80,000 30,000 Other expenses (F) 60,000 60,000 - Total 640,000 825,000 185.000 ‘Net Income P.260,000 P_375,000 P_115,000 V= Variable F = Fixed The differential revenue is P 300,000, and the differential costs total P 185,000, leaving a positive differential net income of P 115,000 under the proposed marketing plan, As noted earlier, those differential costs representing cost increases could have been referred to more specifically as incremental costs, and those representing cost decreases could have been referred to more specifically as decremental costs. Relevant cost A future cost that changes across the alternatives. In the example above, the relevant costs are cost of goods sold, advertising, commissions, and warehouse depreciation. Out-of-pocket cost Cost that requires the payment of money (or other assets) as a result of their incurrence. Sunk cost34 Cost Accounting e used in future decision, they are not differential costs, and therefore they should be analyzing future courses of action. To illustrate the notion of a sunk cost, assume that a firm has just paid P anand @ special purpose machine. Since the cost outlay has been made, the P250, investment in the machine is a sunk cost. Even though the purchase may have been unwise, no amount of regret can relieve the company of its decision, nor can any future decision cause the cost to be avoided, Controllable and Non-controllable Costs A.cost is considered to be a controllable cost at a particular level of management if that level has power to authorize the cost. For example, entertainment expense would be controllable by-a sales manager if he or she had power to authorize the amount and type of entertainmeit for customers. On the other hand, depreciation of warehouse facilities would not be controllable by the sales manager, since he or she would have no power to authorize warehouse construction, In some situations, there is a time dimension to controllability. Costs that are controllable over the long run may not be controllable over the short run. A good example is advertising. Once an advertising program has been set and a contract signed, management has no power to change the amount of spending. But the contract expires, advertising costs can be renegotiated, and thus management can exercise control over the long run. COST FLOW - MANUFACTURING FIRMS Cost incurrence Expense Category Direct materials --- Direct labor --- —-Work in _, Finished __, Cost of goods sold J process” goods Factory overhead Selling and Administrative |§ —__________, Operating expensesChapter 2 Cost— Concepts and Classification 35 Work in process consists of goods that are started but not comy ini pleted. Finished goods are goods that are complete and ready for sale, 7 COST FLOW - MERCHANDISING FIRM Cost incurrence Expense category Finished goods Cost of goods sold Selling and Administrative Operating expense COST FLOW - SERVICE FIRM Cost incurrence Expense category Direct materials -----} Direct labor ----------- ae Cost of services Factory overhead -—-- } Selling and Administrative ________, Operating expense The essential purpose of any organization is to transform inputs into outputs. The activity for merchandising, manufacturing, and service organizations are shown in the previous and current page . These organizations have many similarities, all require labor and capital as inputs, and all transform them into a product or service for the market. These organizations also differ from, one another in many respects. The differences between these organizations are reflected in their accounting systems. A merchandising organization starts with a finished product and markets it. Because inventory is acquired in finished form, its cost is easily ascertained. The accounting system for a manufacturing organization is more complex because direct materials are first acquired and then converted to finished products. A manufacturer’s accounting system focuses on work in process, which is the account that reflects the costs involved in transforming input materials into finished goods.36 Cost Accounting zi ising because zrvice organizations are diferent from manufacturing and ily centers they have no inventory of goods for sale. Costs are charge 7 example, costs are for performance evaluation, In a public accounting firm, for exampi, coms Ore harged to the audit department, the tax department, and so forth. Costs are also charged to jobs. The assignment of costs facilitates Er department, the manager of each department is held responsible for the costs o Sis ‘ree kinds of manager of each job is held responsible for the cost of that job .O1 iran tenet Operations, manufacturers require the most complex and compre aking and accounting system. All three uses cost information for decision making “ Performance evaluation. But in addition, manufacturers need product Sn 7 inventory valuation and to measure cost of goods sold reported on external financial Statements. Many manufacturers also have service and merchandising activities, costs of which must be recorded, SUMMARY OF IMPORTANT FORMULAS 1. Total variable costs = Variabie cost per unit x total output 2. Total cost = Total variable cost total fixed coxt 3. Variable rate = highest point cost - lowest point cost Highest output - lowest output 4. Fixed cost = Total cost at highest — (variable rate x output at highest point) or 5. Fixed cost = Total cost at lowest — (variable rate x output at lowest point )