3. Cost Concepts And Classifications (final)

Mindanao State University College of Business Administration and Accountancy

DEPARTMENT OF ACCOUNTANCY Marawi City

COST CONCEPTS AND CLASSIFICATIONS Accounting 142

MEANING OF COST AND ITS USES One objective of management accounting is to determine the cost of products, services, customers and any other items of interest to managers. In understanding costs and as to how it can be used by management, the following terms and concepts are relevant: A. Cost – foregoing or potential expenditures (any form of current or future cash outlay) measured in monetary terms to achieve a specific objective; a sacrifice required to attain a given objective. B. Expenses – measured outflow of goods and services that are matched against revenues to determine income; an expired cost. C. Loss – a form of expired cost that is not beneficial to revenue producing activities of the enterprise; no benefits were derived from this particular cost. D. Cost object – anything for which cost is computed such as a customer, product, a product line or a segment of an organization. E. Cost driver – any variable such as a level of activity or volume that usually affects costs over a period of time. F. Activity – an event, action, transaction, task or unit of work with a specified purpose. Activities can be classified into:  Value adding activities – activities that are necessary or non-eliminable to produce the products such as assembling the different component parts of the product.  Non-value adding activities – activities that do not make the product or service more valuable to customer such as moving the materials and equipment parts from/to stockroom or a workstation. G. Value chain – a set of activities that a firm operating in a specific industry performs in order to deliver a valuable product or service for the organization’s customers.  Research and development – experimenting to reduce costs or improve quality.  Design – developing alternative product, service or process designs.  Supply – managing raw materials received from vendors to reduce costs and improve quality.  Production – acquiring and assembling resources to produce a product or render a service.  Marketing – promoting a product or service to current and prospective customers.  Distribution – delivering a product or service to a customer.  Customer service – supporting customers after the sale of a product or service. H.

Cost pool – a grouping of individual cost items; an account in which a variety of similar costs are accumulated such as work in process and factory overhead control accounts.

CLASSIFICATIONS OF COSTS Costs can be classified in a number of ways depending on the purpose of the classification. Such classifications of costs are not mutually exclusive. A. Classification as to function:  Manufacturing costs – production costs of factory related activities or those that are incurred to transform materials to finished goods.

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B.

Direct manufacturing cost – those that are easily traceable to specific units of production such as direct labor and direct materials. b. Indirect manufacturing cost – those collection of product costs cannot be practically or conveniently traced to end products such as factory overhead. Non-manufacturing costs – the operating expenses of the business or those costs not incurred in transforming materials to finished goods. a. Marketing expenses – distribution expense or selling expensesor those that covers the expenses of making sales and delivery of products sold. b. Administrative expenses – expenses incurred in the direction, control and administration of the organization. c. Research and development – incurred in designing and bringing new products to the market. d. After-sales costs – costs incurred in dealing with customers after sales such as warranty and repair costs.

Classification as to applicability to accounting periods:  Capital expenditures – outlays classified first as an asset before being recognized as expense.  Revenue expenditures – outlays classified directly as an expense.  Product cost – cost included in the calculation of inventory costs; also known as inventoriable costs.  Period cost – costs charged against current period operations and treated as expense immediately.

C. Classification according to managerial influence:  Controllable cost – cost that is subject to influence by a particular manager within the time period under consideration.  Non-controllable cost – cost which a manager does not have a significant influence over. D.

Classification for planning, control and decision making purposes:  Standard cost – costs pegged at a predetermined rate usually expressed on a per unit basis; in total, it is the cost that “should have been incurred” for actual production.  Budgeted cost – future costs usually expressed in totals; in total, the cost represents the “should be incurred” for budgeted production.  Relevant costs – future costs that will differ under alternative courses of actions.  Irrelevant cost – costs that will not affect the decision making process, thus, is ignored in the analysis.  Differential cost – difference in cost between any two alternative courses of action. a. Incremental costs – increase in cost from one alternative to the other. b. Decremental costs – decrease in cost from one alternative to the other.

Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014

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E.

F.

Marginal cost – additional costs expressed on a per unit basis. Postponable costs – costs that may be deferred or shifted to a future date or period of time without adversely affecting current operations. Avoidable cost – cost that can be eliminated in whole or in part when one alternative is chosen over another in a decision making case. Unavoidable cost – costs that remain regardless of what decision or alternative is chosen. Out of pocket cost – cost that require current or future cash outlay. Opportunity cost – cost of benefits foregone as the result of the acceptance of an alternative. It is measured as the benefits that would result from the next best alternative use of the same resources that were rejected in favor of the one accepted. Imputed cost – hypothetical cost representing the usage value of a particular resource. Sunk or past or historical cost – cost which are already incurred and therefore irrelevant in decision making process.

Classification in relation to a cost object:  Direct cost – costs that are related to a particular cost object and can be economically and effectively be traced to that cost object.  Indirect costs – cost that are related to a cost object but cannot practically, economically and effectively be traced to such cost object. Factors affecting the direct-indirect cost classification follow: a. Materiality of the cost in question. b. Design of operations. c. Availability of an information-gathering technology. d. Choice of cost object.  Common cost – cost that benefit more than one activity or department.  Joint cost – apply to situations where multiple outputs are derived from one source. Classification as to the tendency to vary with volume or activity:  Variable cost – within the relevant range and time period under consideration, the total amount varies directly to the change in activity level or cost driver and the per unit amount is constant.

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Fixed cost – within the relevant range and time period under consideration, the total amount remains unchanged and the per unit amount varies inversely or indirectly with the change in the cost driver.

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Committed fixed cost – cost that is an inevitable consequence of a previous commitment; costs to which

Step cost – when activity changes, a step cost shifts upward or downward by a certain interval or step.

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Step variable cost – a step cost that have smaller steps. b. Step fixed cost – a step cost that have larger steps. Non-linear cost – total cost increases but per unit decreases as activity increases.

To analyze curvilinear costs is to determine the relevant range represented by the straightline in the graph. COST BEHAVIOR ASSUMPTIONS In management accounting, cost behavior refers to the way in which costs are affected by fluctuations in the cost driver, i.e. level of activity. An understanding of cost behavior patterns is essential for many management tasks, particularly in the areas of planning, decision-making and control. It would be impossible for managers to forecast and control costs without at least a basic knowledge of the way in which costs behave in relation to the cost driver. Economists correctly point out that many costs that accountants classify as variable costs actually behave in a curvilinear fashion. Nonetheless, within a narrow band of activity, a curvilinear cost can be satisfactorily approximated by a straight line. In determining cost behavior, certain assumptions are assumed by the accountant: A. Relevant range – the band or level of activity where the cost concepts and the relationship of variable and fixed costs are considered valid. In the relevant range, the following holds true:

B. a.

management is “stuck” with over an extended period of time such as depreciation and long-term lease contract. b. Programmed or discretionary or managed costs – cost for which the size or the time of incurrence is a matter of choice of management such as advertising costs and research and development costs. Mixed cost – this cost has both a variable and a fixed component.

Total Amount Per Cost Driver Variable cost Variable Constant Fixed cost Constant Variable Linearity assumption – within the relevant range, there is a strict linear relationship between the cost and cost driver. Costs may therefore be shown as straight lines.

Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014

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C. Time assumption – the cost behavior patterns identified are true only over a specified period of time. Beyond this, the cost may show a different behavior pattern. Accountants should also be aware that a cost that is considered variable in one organization may be considered fixed in another due, for example, to differing employment policies. DETERMINING THE COST FUNCTION FOR MIXED COSTS Mixed costs have variable and fixed cost components, thus: Total cost (TC) = Fixed cost (FxC) + Variable Cost (VC) Total variable cost varies directly with the activity level or cost driver, thus: Variable cost (VC) = Variable cost per cost driver (b) x Cost driver (x) Since total cost is linearly related to the activity level or cost driver, the cost function may be expressed as: Y = a + bx where: Y – is the total cost; a – is the total fixed cost; b – variable cost per cost driver; x – activity level or cost driver. Needless to say, purely fixed costs may be expressed as Y = a and purely variable costs as Y = bx. COST ACCOUNTING AND COST ACCOUNTING SYSTEMS Cost accounting is that part of the accounting system that measures costs for decision-making and financial reporting purposes. It involves the two processes namely: A. Cost accumulation – involves collection of cost data in some organized means in an accounting system. B. Cost assignment – involves tracing and allocating accumulated costs to cost objects. Examples of cost accounting systems commonly used by businesses include: A. Job order costing – this product costing system is used by firms that provide limited quantities of products or services unique to a customer’s needs or specifications. Costs are assigned or traced to individual products. Examples: automobile repair shops and tailoring/dressmaking business. B. Process costing – this system is used by firms that produce many units of a single product or nearly identical products for long periods at a time. Examples: soft drinks company and toy manufacturers. C. Hybrid product-costing system – this costing system incorporate features from two or more alternative product costing systems such as job order and process costing. Examples: clothing and food processing operations. D.

Standard costing – this method uses predetermined factors to compute the standard cost of materials, labor and factory overhead so that such costs may be assigned to the various inventory accounts and cost of goods sold and can be used with the other cost accounting systems.

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F.

Backflush costing – this is a streamlined cost accounting method that simplifies, speeds up and reduces accounting effort or procedures in accumulating product costs. Unlike in the traditional job order and process costing systems, backflush costing eliminates the detailed tracking of the cost of work in process. Activity-based costing system – this costing system uses multiple drivers to predict and allocate costs to products and services.

FLOW OF COSTS IN A FIRM Cost flow refers to the manner in which costs move through a firm specifically in its accounts and how such costs affect the firm’s statement of financial position and income statement. Merchandising Firm Purchases Freight or transportation in Total Purchase discounts Purchase returns and allowances Net purchases

P xxx P xxx P xxx (xxx) (xxx) P xxx

Merchandise inventory, beginning Net purchases Total goods available for sale Merchandise inventory, ending Cost of goods sold Sales Cost of sales Gross profit Operating expenses Operating income Other income Other expenses Income before tax Income tax Net income

P xxx P xxx P xxx (xxx) P xxx P xxx (xxx) P xxx (xxx) P xxx P xxx (xxx) P xxx (xxx) P xxx

Manufacturing Firm For a manufacturing firm, the cost of goods sold is computed differently as the goods purchased are not sold as is but rather transformed first before being sold to customers. Raw materials inventory, beginning Net purchases Total raw materials available for use Raw materials inventory, ending Direct materials used Direct labor Manufacturing overhead Total manufacturing costs Work in process, beginning Total costs placed into production Work in process, ending Total cost of goods manufactured Finished goods, beginning Total goods available for sale Finished goods, ending Cost of goods sold

P xxx P xxx P xxx (xxx) P xxx P xxx P xxx P xxx P xxx P xxx (xxx) P xxx P xxx P xxx (xxx) P xxx

ILLUSTRATIVE PROBLEMS PROBLEM 1: Classify the following selected costs below as variable (V) or fixed (F) cost, product (P) or period (E) cost and direct (D) or indirect (I) cost in relation to units or product. _____ _____ _____ 1. Wood is used in the manufacture of tables at a cost of P100 per table. _____ _____ _____ 2. The tables are assembled by workers at a cost of P40 per table. _____ _____ _____ 3. Workers assembling the tables are supervised by a factory supervisor who is paid P25,000 per month.

_____ _____ _____ 4. Electrical costs of P20 per machine hour are incurred in the factory in the manufacture of tables. Four machine hours is needed to manufacture one table. _____ _____ _____ 5. The depreciation cost of the machines used in the manufacture of the tables is P40,000 a year. _____ _____ _____ 6. The salary of the president of the company is P100,000 a month. _____ _____ _____ 7. The company spends P250,000 per year to advertise its products.

Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014

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_____ _____ _____ 8. Salespersons are paid a commission of P300 for each table sold. _____ _____ _____ 9. Rent paid for the factory building is P20,000 a month. _____ _____ _____ 10. Insurance premiums paid for the general office is P15,000 a year.

B.

The cost of including one extra child in a day-care center. C. The cost of merchandise inventory purchased five years ago. The goods are now obsolete. D. The management of a high-rise office building uses 3,000 square feet of space in the building for its own administrative functions. This space could be rented for P30,000. What economic term describes this P30,000 of lost rental revenue? E. The cost of building an automated assembly line in a factory is P700,000. A manually operated assembly line would cost P250,000. What economic term is used to describe the P450,000 variation between these two amounts? F. Refer to the preceding question and assume that the firm is currently building the assembly line for P700,000. What economic term is used to describe the P700,000 construction cost?

PROBLEM 2: Classify the following fixed costs as normally being either committed (C) or discretionary (D). ______1. Depreciation of buildings used in manufacturing operations. ______2. Planned expenditures for research and development. ______3. Lease or rent of equipment on a long-term basis. ______4. Payments of pensions to the retirees of the firm. ______5. Budgeted costs for management training and development. PROBLEM 3: For items 1 to 9 that follow, draw a graph that best represents the cost behavior pattern described. 1. Straight-line depreciation on machineries and equipment. 2. The cost of chartering a private airplane. The cost is P800 per hour for the first 6 hours of a flight; it then drops to P600 per hour. 3. The wages of table service personnel in a restaurant. The employees are part-time workers who can be called upon for as little as 4 hours at a time. 4. Weekly wages of store clerks who work 40 hours each week. One clerk is hired for every 125 sales made during the month. 5. The cost of tires used in the production of trucks. 6. Outbound shipping charges that increase at a decreasing rate as sales rise because the firm can use more efficient modes of transportation. Gradually, however, at high levels of sales, freight costs start to increase at an increasing rate, which reflects more transactions made to customers in faraway locations. 7. Equipment leasing costs that are computed at P2 per machine hour worked. The company pays a maximum of P120,000 per month. 8. The monthly cost of a franchise fee for a fast-food restaurant. The franchisee must pay P20,000 plus 5% of gross dollar sales. 9. The cost of electricity during peak demand periods, which is based on the following schedule: up to 20,000 kilowatt hours – P4,000; above 20,000 kilowatt hours – P4,000 + P0.02 per kilowatt hours. PROBLEM 4: Walnut Corporation operates a small medical lab in Kansas, one that conducts minor medical procedures, including blood tests and x-rays for a number of doctors. The lab consumes various medical supplies and is staffed by two technicians, both of whom are paid a monthly salary. In addition, there is an on-site office manager who is also paid by the month. Requirements: 1. 2.

If the lab's patient count increases by, say, 15%, will the lab's total operating costs increase by 15%? Explain. Walnut is considering opening an additional lab in a new suburban medical building. What will likely happen to the lab's level of fixed cost incurrence? Why?

PROBLEM 5: The following terms are used to describe various economic characteristics of costs: Opportunity cost Differential cost Sunk cost Out of pocket cost Marginal cost Average cost Choose one of the preceding terms to characterize each of the amounts described below. Each term may be used only once. A. The cost of feeding 300 children in a public school cafeteria is P450 per day or P1.50 per child per day. What economic term describes this P1.50 cost?

PROBLEM 6: Following are costs incurred by Deadwood Manufacturing Corporation during the previous month: Direct materials P 100,000 Indirect materials (sand papers, lubricants, nails, rivets, paint and similar items) 5,000 Direct labor 50,000 Indirect labor (salary of plant supervisor and similar items) 10,000 Factory light, heat, water and electricity 4,000 Advertising and selling costs 6,000 Sales commissions of agents 5,000 Depreciation on administration building 3,000 Salaries of administrative personnel 20,000 Depreciation on delivery equipment 3,000 Depreciation of plant equipment 2,000 Insurance on administration building 2,500 Depreciation of plant buildings 15,000 Property taxes on plant buildings 4,000 Insurance on plant buildings 2,500 Requirements: 1. 2.

Compute for Deadwood’s total product costs and total period costs for the current month. Compute for Deadwood’s total conversion costs for the current month.

PROBLEM 7: The following selected costs were extracted from the accounting records of Los Angeles Machining: A. Direct materials used in production. B. Wages of machine operators. C. Factory utilities. D. Uncollectible accounts expense. E. Sales commissions. F. Salary of Los Angeles Machining's president. G. Factory depreciation. H. Wages of plant security guards. I. Machine lubricant used in production. Identify the costs that would be used to calculate (a) cost of goods manufactured (b) manufacturing overhead, (c) total period costs, (d) total conversion costs, (e) total direct costs of the credit and collections department and (f) inventory valuation. PROBLEM 8: Data about Cisco Company’s production and inventories for the month of June are as follows: Purchases of direct materials P 143,440 Freight in 5,000 Purchase returns and allowances 2,440 Direct labor 175,000 Actual factory overhead 120,000 Inventories: Finished goods, June 1 68,000 Finished goods, June 30 56,000 Work in process, June 1 110,000 Work in process, June 30 135,000 Raw materials, June 1 52,000 Raw materials, June 30 44,000 Cisco Company applies factory overhead to production at 80% of direct labor cost. Over or underapplied overhead is

Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014

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closed to cost of goods sold at year-end. The company’s accounting period is on a calendar year basis. Requirements: 1. 2.

What was the amount of over or underapplied factory overhead for the month of June? Prepare in good form a cost of goods sold statement for Cisco for the month of June.

PROBLEM 9: Mighty Muffler, Inc., operates an automobile service facility. The table below shows the cost incurred during a month when 600 mufflers were replaced. Number of Muffler Replacements 500 600 700 Total costs: Fixed costs A P 8,400 J Variable costs B 6,000 K Total C P14,400 L Cost per muffler replacement: Fixed cost D G M Variable cost E H N Total F I O Fill in the missing amounts, labeled A through O, in the table. PROBLEM 10: Axle and Wheel Manufacturing currently produces 1,000 axles per month, though its plant has a capacity of 2,000 axles per month. The following per unit data apply for sales to regular customers: Direct materials P 200.00

Direct manufacturing labor Variable manufacturing overhead Fixed manufacturing overhead

30.00 60.00 40.00

Requirements: 1. What is the total cost of producing 1,000 axles, 1,500 axles and 2,000 axles respectively? 2. What is the per unit cost when producing 1,000 axles, 1,500 axles and 2,000 axles respectively? PROBLEM 11: The Morton Company recorded the following transactions for February 2011:

Purchases Beginning inventory Ending inventory Direct materials used Direct labor Manufacturing overhead (inclusive of indirect materials used of P10,000) Transferred to finished goods Cost of goods sold

Raw Materials P 100,000 18,000 ?

Work in Process P 8,000 20,000 90,000 ? 115,000

?

Finished Goods ? P 30,000

?

Sales were P560,000, with sales prices determined by adding a 40% markup to the firm's manufacturing cost. The total cost of direct materials used, direct labor, and manufacturing overhead during the month was P285,000. Calculate the missing values in the records above.

Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014

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