CHAPTER II

INTRODUCTION TO COST TERMS AND COST CLASSIFICATIONS

1. Cost information and organizations

In the case of manufacturing organization the product costs include the cost of direct materials,
direct labor and manufacturing overhead.

For a retail organization, the cost of a purchased product includes adjustments like freight in
costs, purchase returns and allowances and purchase discounts.

On the other hand in service organization the costs to provide a service include the cost of labor
and related overhead.

Ultimately, a company is profitable only when revenues from sales or services rendered exceed
all its costs including both the costs of products and services and operating costs.

2. Costs and Cost Terminology

2.1. Cost: According to Carl .S. Warren the term cost refers to all payments of cash for the
purpose of generating revenues. Costs can be either expressed or capitalized. Expensed costs are
treated as expresses in the period cash is paid. Capitalized costs are treated as assets in the period
cash is paid. The asset is recognized as expenditure in future periods.

According to J. Horngren cost refers as resource scarified or foregone to achieve a specific

objective. It is usually measured as the monetary amount that must be paid to acquire goods and
services.

2.2. Cost object: A cost object is anything for which a separate measurement of costs is desired.
Examples include a product, service, project, customer, brand category, activity, department, etc
There are two stages for accounting of costs (1) cost accumulation and (2) cost assignment. Cost
accumulation is the collection of cost data in some organized way by means of an accounting
system. Cost assignment means tracing accumulated costs to cost object and allocating
accumulated costs to a cost object.

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3. Classification of Costs

3.1. Direct Costs and Indirect Costs

Direct costs are costs that can be conveniently or economically traced to a cost object. For
example, the cost of the cans or bottles is a direct cost of a Pepsi soft drink. The cost of the cans
or bottles can be conveniently and economically traced to the Pepsi soft drink.

The other example, the wages of production line workers can be conveniently traced to the
product because the time worked and the related hourly wages can be easily found by looking at
time cards and payroll records. Similarly the cost of an engine can be easily traced to an
automobile’s cost.

Indirect costs are costs that cannot be conveniently or economically traced to a cost object.
Examples include nails in furniture, bolts in automobiles, and rivets in airplanes. The other
example, the cost of quality control personnel who can’t taste and content tests on multiple soft
drink products bottled at a Pepsi plant is an indirect cost of a Pepsi soft drink. Unlike cans or
bottles, it is difficult to trace quality control personnel costs to a specific Pepsi soft drink. A cost
can be direct regarding one cost object and indirect regarding other cost objects.

3.2. Cost behavior Patterns: Variable, Fixed and Mixed Costs

Managers are also interested in the way costs respond to changes in volume or activity. By
analyzing those patterns of behavior, managers gain information about how changes in selling
prices or operating costs affect the net income of the organization.
Costs can be separated into variable costs, fixed costs ands mixed costs..

3.2.1. Variable cost: Variable cost changes in total in proportion to changes in the related level
of total activity or volume.
Example, If Ford buys a steering wheel at $ 100 for each of its Ford Explorer vehicles, then the
total cost of steering wheel should be $100 times the number of vehicles assembled. Total
steering wheel costs are an example of a variable cost, a cost that changes in total in proportion
to changes in the number of vehicles assembled.

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Exhibit 2-1 displays a graph of a 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 $1,000 to & 2,000. However, cost associated with each unit of activity is & 100,
whether it is the first unit, the fourth, or the eighteenth. To summarize, as activity changes, total
variable cost increases or decreases proportionately with the activity change, but unit variable
cost remains the same.

Exhibit 2-1: variable cost

Total variable cost

$3,000

$2,000

&1,000

Activity (or cost driver)

10 20 30

Tabulation of variable cost

Activity
(Cost driver) variable cost per unit Total variable cost

1-----------------------$100----------------------------------------$100
4-----------------------100-------------------------------------------400
18----------------------100-----------------------------------------1800
30----------------------100-----------------------------------------3000

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3.2.2. Fixed Cost: A fixed cost remains unchanged in total for a given time period despite wide
changes in the related level of total activity or volume. Costs are defined as variable or fixed with
respect to a specific cost object and for a given time. If activity increases or decreases by n%
within the given relevant range, total fixed cost remains the same; but the per unit fixed cost
changes.
E.g. Salary of plant manager, monthly rental cost of equipment and /or house,
depreciation of machines used to produce furniture’s at $10,000 per year and the like.
Exhibit 2-2: Fixed cost
Total fixed cost

$1,500

10 20 30 Activity (or cost driver)

Tabulation of fixed cost

Activity Fixed cost per unit Total fixed cost
(Or cost driver)

1----------------------------$1,500.00---------------------------$1,500
2-------------------------------750.00-----------------------------1,500
5-------------------------------300.00-----------------------------1,500
10-----------------------------150.00------------------------------1,500
11-----------------------------136.36------------------------------1,500
20-------------------------------75.00------------------------------1,500
21-------------------------------71.43------------------------------1,500
30-------------------------------50.00------------------------------1,500

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3.2.3. Mixed costs of semi variable or semi fixed costs

A mixed cost has characteristics of both a variable and a fixed cost. For example, over one range
of the activity base, the mixed cost may remain content in total amount, and thus be fixed. Over
another range of activity, the mixed cost may change in proportion to changes in the activity base
and will be variable.
For example, for using rented machinery the rental change is $ 20,000 per year hrs $ 2 per each
machine hour used. If the machinery is used for 30,000 hours, the total rental changes are $
80,000 (20,000 + 30,000) and of the machinery is use for 20,000 hours the rectal changes are $
60,000 (20,000x(2000x2)) and so on. Other examples of mixed costs, telephone cost, the costs of
electricity and gas.

4. Cost Drivers is one of the most important cost concepts is the way a cost changes in relation
to changes in the organization activity. Activity is any discrete task that an organization
undertakes to make or deliver a good or service. The number of computers manufactured by
IBM, the number of days of patient care provided by the clinic and the number of loans issued by
the Commercial Bank of Ethiopia are all measures of output activity. The activities that cause
costs to be incurred are called “cost drivers.”
A cost Driver is characteristics of an activity or event that causes that activity or event to incur
costs. The cost driver of variable costs is the level of activity or volume whose change causes the
(variable) costs to change proportionately. For example the number of vehicles assembled is a
cost driver of the cost of steering wheels. 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.
The following are the examples of cost and cost drivers.

Cost Examples of cost Drivers.

a) Cost of food at hospital
b) Fuel cost at transport corporation
c) Cost of handling insurance claims by
Insurance Corporation.
d) Cost of material handling at manufacturing
company
e) Cost of taking customer orders at
manufacturing company
Number of days of patient care.
Number of tons of cargo transported; distance
flown
Number of claims processed.
Number of materials moves, weight of
material handled, type of material handled.
Number of customers’ orders, type of products
ordered.

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  Relationships of Types of Costs

The two major classifications of costs: Direct cost / Indirect cost and Variable/ Fixed costs. Costs
may be simultaneously being:
 Direct and Variable
 Direct and Fixed
 Indirect and Variable
 Indirect and Fixed.
Examples of costs in combinations of the Direct / Indirect and variable/ fixed cost classifications.
Assignment of costs to cost object.

Direct Cost Indirect Cost

Variable Cost Cost object: Toyota Car Cost object: Toyota car
Example: Tires used in Example: Power cost at plant.
Cost Behavior assembly of automobile
Pattern
Cost Object: Toyota Car Cost object: Toyota Car
Fixed Cost Example: Salary of Example: Annual lease costs at
supervisor in Toyota car plant. Lease is for whole plant
assembly line at which multiple products are
assembled.

 Manufacturing, Merchandising and Service- Sector Companies:

 Manufacturing Sector Companies: They purchase raw materials and other

components
 and convert them into finished products. Examples are Textile manufacturing
 companies, TV manufacturing companies etc.

 Merchandising – Sector Companies: They purchase and sell tangible products

without changing their basic form. This sector includes companies engaged in
retailing, distribution or wholesaling.

 Service Sector Companies: They provide services or intangible products to their

customers. Examples are law firms, accounting & audit firms, banks, Insurance
Companies, transportation companies, advertising agencies, radio and television
stations and Internet based companies.

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  Financial Statements, Inventoriable Costs, and Period Costs:

The distinction between inventoriable costs and period costs is a key one in the generally
accepted accounting principles that govern financial reporting. The following are different types
of inventory that companies hold and some commonly used classifications of manufacturing
costs.

Types of Inventory

a) Manufacturing-sector companies: They purchase materials and

components and convert them into different finished goods. They typically have one or
more of the following three types of inventories:

i) Direct material inventory: - Direct materials in stock and awaiting use in the
manufacturing process.
ii) Work in process inventory: - Goods partially worked on but not yet fully completed.
also called work in progress.
iii) Finished goods inventory: Goods fully completed but not yet sold.

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 intangible
products to their customers and hence do not hold inventories of tangible products for sale.

 Commonly used classification of Manufacturing Costs

There are three elements involved for the products produced by a manufacturing concern. The
three elements of products cost are (a) Direct material costs (b) Direct labor cost and (c)
Manufacturing overhead costs, which are indirect manufacturing costs.

(a) Direct Material Costs: - All manufactured products are made from basic direct
materials. Direct materials are the acquisition costs of materials that can be
conveniently and economically traced to specific unit of product. Acquisition cost of
direct materials includes freight –in charges, sales taxes and customs duties. Some
examples of direct materials are iron ore for steel, sheet steel for automobiles and
sugar for candy.

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 (b) Direct Labor Costs: - The manufacturing process includes all activities required to
make a product, including maintenance, handling, inspection, moving and storing.
Direct labor costs are the costs of labor to complete production activities that can be
conveniently and economically traced to specific units of product. The wages of
machine operators and other workers involved in actually shaping the product are
direct labor costs.

(c) Manufacturing Overhead Costs: The third elements of product cost include all
manufacturing costs that cannot be classified as direct materials or direct labor costs.
Manufacturing overhead costs are production related costs that can’t be practically or
conveniently traced directly to an end product. This assortment of costs is also called
factory overhead, or indirect manufacturing costs. Two common components of
manufacturing overhead costs are indirect material costs and indirect labor costs.

i) Indirect material costs are the costs of materials that cannot be conveniently or
economically traced to a unit of product e.g. cost of nails, reverts, lubricants and
small tools.
ii) Indirect labor Costs are labor costs for production related activities that cannot
be conveniently or economically traced to a unit of product. E.g. cost of labor for
maintenance, inspection, engineering design, supervision, materials handling and
machine handling.

iii) Other indirect manufacturing costs: Cost of building maintenance, machine and
tool, maintenance, property taxes, property insurance, depreciation on plant and
equipment, rent and utilities. As indirect costs, manufacturing overhead cost is
allocated to a products cost using traditional or activity based costing methods.

 Product cost or Inventoriable Costs:

For financial reporting purposes, costs are often classified as either product costs or period cost.

 Product costs

Product Costs are composed of the three elements of manufacturing cost: Direct Material,
Direct Labor and Factory overhead. These costs are treated as assets until the product is sold. In
other words, costs are accumulated as inventory until the product is sold, at which time the

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inventory is transferred to cost of goods sold. Thus, direct material, direct labor and factory
overhead costs incurred in one period will not appear on the income statement as expense until
the products with which they are associated are sold.

For merchandising – sector companies, product costs are the costs of purchasing the goods that
are resold in the same form including freight costs (inward).

For service sector companies, the absence of inventories means there are no inventoriable costs.

 Period Costs

Period costs are all goods in the income statement other than cost of goods sold. These costs are
treated as expenses of the period in which they are incurred because they are assumed not to
benefit future periods. Expensing these costs immediately best matches to revenues.

For manufacturing sector companies, period costs include all non-manufacturing costs for
example, selling cost, administration cost and Research and Development costs.

For merchandising-sector companies, period costs includes all costs not related to the cost of
goods purchased for resale in the same form (for example, labor cost of sales floor personnel and
marketing costs)
For service sector companies, since there are no inventoriable costs, all their costs are period
costs.

 Prime Cost and Conversion Costs:

In manufacturing companies, the costs are classified as Prime Cost and conversion costs.

Prime costs are all direct manufacturing costs, i.e all direct material costs and direct
manufacturing labor cost. The prime costs also include direct material cost, direct manufacturing
labor cost and direct metered power cost (power costs might be metered in specific areas of a
plant that are dedicated totally to the assembly of separate products)

Conversion Costs are all manufacturing costs other than direct material costs. Conversion costs
are the costs incurred to convert direct material into the final product, namely, costs for direct
labor and manufacturing overhead.

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 Controllable and Uncontrollable Costs

Controllable costs are those costs, which can be influenced by the action of a specified member
of the undertaking. If a manager can control or heavily influence the level of cost, then that cost
is classified as a controllable cost of that manager.

Costs that a manager cannot influence significantly are classified as uncontrollable cost of that
manager.

The officer in charge of a particular department or cost center can control costs only of those
matters, which come directly under his control, but not of other matters. For example, the
expenditure incurred by the Tool Room is controllable by the foremen in charge of that section
but a machine shop foreman cannot control the share of the tool room expenditure, which is
apportioned to a machine shop.

Many costs are not completely under the control of any individual. In classifying costs as
controllable or uncontrollable, managerial accountants generally focus on a manager’s ability to
influence costs.

Some costs may be controllable in the long run but not in the short run. For example, the long
term costs associated with computing equipment leased by an organization are controllable when
the 10-year lease is negotiated. In the short run, however, after the lease is signed, the rental costs
are uncontrollable until the lease period ends.

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Exhibit 2-4: Summary of manufacturing cost terms
Manufacturing costs
(Also called product costs)

Direct Materials Direct labor Manufacturing overhead

All costs of
manufacturing
Materials that can be Labor cost that can be a produce other
than direct
Physically and conveniently physically traced to the materials and
direct labor,
traced into a product creation of a product factory utilities
and depreciation
(such as wood in a table) in a`` hands on`` sense (such as of factory
buildings and
assembly-line worker in a plant). Equipment)
and the like.

Prime cost conversion cost

Nonmanufacturing costs
(Also called period costs)

Marketing or selling cost Administrative costs

All costs necessary to secure customer All costs of general

administration
orders and get the finished products or of the company as a
whole (such as
services into the hands of the customer executive compensation,
executive
(such as sales commissions, advertising, travel costs, secretarial
salaries, and
and depreciation of delivery equipment depreciation of office
buildings and
and finished goods warehouses). equipment).

 Financial Statements for Manufacturing Enterprises :

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The financial statements for manufacturing enterprises are more complex than those for service
and merchandising enterprises.
For merchandising enterprises purchase costs are accumulated to determine the merchandise
available for sale. The total merchandise available for sale can be divided in to two portions the
portion sold and the portion remaining. The portion sold is expensed as cost of merchandise sold,
while the remaining portion is merchandise inventory. For both merchandisers and
manufacturers, period costs are expressed immediately as selling and administrative expenses.

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. The finished goods inventory of a manufacturing enterprise consists of the finished
products on hand that have not been sold. The cost of partially completed goods is an asset called
work in process inventory. The work in process inventory for a manufacturing enterprise consists
of the direct material costs, the direct labor costs and the factory overhead cost incurred but they
have not been finished.

Since a manufacturing organization manufactures the product that it sells, the manufacturing
costs must be properly accounted for and reported in the financial statements. These
manufacturing costs primarily affect the balance sheet and income statement, which are
explained as follows.

11.1. Balance sheet for a manufacturing Enterprise

A manufacturing enterprise reports three types of inventory on its balance sheet: Direct materials
inventory, work in process inventory, and finished goods inventory.

Flow of manufacturing costs to balance Sheet.

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 Manufacturing Balance sheet
costs

Direct Material Unused Direct Materials

costs Inventory.

Work in
process
Used Manufacturing
Direct labor cost Inventory
process Unfinished

Factory overhead
costs
Finished
goods
Inventory

The direct materials inventory for a manufacturing consists of the cost of the direct materials that
have not yet entered in to the manufacturing process.
 Income Statement for a Manufacturing Enterprise
Merchandise enterprise:
For merchandise enterprise, merchandise is purchased in a finished state for resale to customers.
The merchandiser only needs to record the invoice price and transportation changes to determine
the cost of the product. The Merchandise that is sold is called the cost of merchandise sold.
Exhibit
Income Statement of Merchandise Enterprise.
REAL INCORPORATION
INCOME STATEMENT
For the year ended December 31, 2015.

Sales $5,200,000
Cost of Merchandise sold 3,950,000
Gross profit 1,250,000
Operating expenses:
Selling expense 400,000
Administrative expense 300,000
Total operating expense 700,000

Net Income 550,000

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The above income statement, which determines the gross profit by subtracting the cost of
merchandise sold from sales. The period costs are shown below the gross profit.

9. Manufacturing Enterprise:

For manufacturing enterprises, the product to be sold is manufactured by converting direct

materials with direct labor and factory overhead in to finished product. The manufacturer must
accumulate the cost of making the produce before determining the cost of the inventory and the
cost of goods sold.

The manufacturer prepares two statements: One the Income statement and the second is the
statement of costs of goods manufactured. The manufacturing costs are summarized in the
statement of cost of goods manufactured. The statement lists the costs that were incurred in
manufacturing the product during the period. The statement summarizes the three major
manufacturing cost elements: direct materials, direct labor and factory overhead.

In Income statement the cost of goods manufactured is added to the beginning finished goods
inventory to determine the total cost of goods available for sale. Subtracting the ending finished
goods inventory gives the cost of goods sold for the period. The gross profit is arrived by
deducting cost of goods sold from the sales. The Net income is arrived after deducting the total
operating expenses from gross profit.
Exhibit: -Manufacturing Income Statement
Goldwin Manufacturing Company
Income Statement
For the year ended, December 31, 2015

Sales $ 1,250,000
Cost of goods sold:
Finished goods inventory, Jan1, 2002 80,000
Cost of goods manufactured 700,000
Cost of finished goods available for sale 780,000
Less: finished goods inventory, Dece31, 2002 100,000
Cost of goods sold 680,000
Gross profit 570,000
Operating expense:
Selling expense 200,000
Administrative express 100,000
Total operating expense 300,000
Net Income 270,000

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 Exhibit : Statement of cost of goods manufactured.
Goldwin Manufacturing Company
Statement of cost of goods manufactured
For the year ended December 31, 2015

Beginning work in process inventory, Jan. 1,2015 40,000

Direct materials:
Beginning inventory, January 1, 2015 70,000
Purchase of direct materials 500,000
Cost of materials available for use 570,000
Ending inventory, December 31,2015 (50,000)
Direct materials used 520,000
Direct Manufacturing labor 70,000
Indirect Manufacturing costs:
Indirect manufacturing labor 50,000
Supplies 15,000
Heat, light and power 35,000
Depreciation –Plant Building 15,000
Depreciation – Plant Equipment 20,000
Miscellaneous 5,000
140,000
Manufacturing costs incurred during the period 730,000
Total manufacturing costs to account for 770,000
Deduct: Ending work in process inventory, Dec31, 2002 (70,000)

Cost of goods manufactured (to income statement): 700,000

Exhibit- Cost Flow statement Relationship.

Statement of cost of goods Manufactured

Direct Material used in Production

+ Direct labor
+ Factory Overhead
+ Work in Process
Beginning inventory Income Statement

-Ending work in Process Finished goods

Inventory Beginning inventory

Cost of goods Manufactured + Cost of goods manufactured

- Finished goods
Ending Inventory
Cost of goods sold customers

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 Production Costs in Service Industry Firms and non-profit organizations .

Service industry firms and many non-profit organizations are also engaged in production. The
distinguishing feature of the service organization from manufacturing organization is that a
service is consumed as it is produced, whereas a manufactured product can be stored in
inventory. Such businesses as hotels, banks, airlines, professional sports franchises and
automotive repair shops are in the business of producing services. While less commonly
deserved in service firms, the same cost classifications used in manufacturing companies can be
applied.

The process of recording and classifying costs is important in service industry firms and non-
profit organizations for the same reasons as in manufacturing firms. Cost analysis is used in
pricing banking and insurance sector, locating travel and car rental agencies, setting enrollment
targets in Universities and determining cost reimbursements in hospitals. As such organizations
occupy an ever-growing role in our economy, applying managerial accounting to their activities
will take on ever-greater importance.
Economic Characteristics of Costs

Managerial accountants also employ economic concepts in classifying costs. Such concepts are
often useful in helping accountants decide what cost information is relevant to the decisions
faced by the organization’s manager. The following are the important economic characteristic of
cost.

 Opportunity cost.

An opportunity cost is defined as the benefit that is scarified when the choice of one action
precludes taking an alternative course of action. If goat meat and fish are the available choices
for dinner, the opportunity cost of eating goat meat is the foregone pleasure associated with
eating fish.

The opportunity costs also arise in personal decisions. The opportunity cost of a student’s college
education includes the salary that is forgone as a result of not taking a full time job during the
student’s years in college.

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The opportunity cost arises in many business decisions. For example, suppose T.V. sets
manufacturer receives a special order for portable TV set. If the firm accepts the portable TV sets
order, it will not have productive capacity (labor and machine house) to produce its usual output
of 17” TV sets for sale to a large chain of TV set stores.

The opportunity cost of accepting the portable TV sets is the forgone benefit from the 17”TV sets
production that can’t be achieved. This forgone benefit is measured by the potential revenue
from the portable TV sets sales minus the cost of manufacturing the 17”TV sets.

From an economic perspective, a dollar of opportunity cost associated with an action should be
treated as equivalent to a dollar of out of pocket cost. Out of pocket costs are those that require
the payment of cash or other assets as a result of their incurrence. The out of pocket costs
associated with the portable TV sets order consists of the manufacturing costs required to
produce the portable TV sets. In making the division to accept or reject the portable TV set order,
the firm’s management should consider both the out of pocket cost and the opportunity cost of
order.
 Sunk Costs

Such costs are past or historical cost. These are costs, 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.
Investments in plant and machinery, buildings, etc., are important examples of such costs. Since
later decisions can’t alter sunk costs, they are irrelevant for decision-making.

Example: ABC Ltd purchased a machine for $6 million. The machine has an operating life of 5
years having no scrap value. After purchase of the above asset the management feels that the
machine should not have been purchased since it cannot yield the operating advantage so
expected. Although it is expected to result in savings in operating costs of $3million over a
period of 5 years, the machine can be sold immediately for a sum of $4 million.

In taking the decision whether the machine should be sold or be used, the relevant accounts to be
compared are $3 million in cost savings over five years and $4 million that can be realized in
case it is immediately disposed of $6 million invested in the asset is not relevant since it is the
same in both cases. The amount is the sunk cost. ABC Ltd should therefore, sell the machinery

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for $ 4million since it will result in an extra profit of $1 million as compared to keeping and
using it.

 Differential Cost

The difference in total cost between two alternatives is known as differential cost. In case the
choice of an alternative results in increase in total cost, such increased costs are known as
incremental costs. While assessing the profitability of a proposed change, the incremental costs
are matched with incremental revenue.

Differential cost is a technique used in the preparation of adhoc information in which only cost
and income differences between alternative courses of action are taken into consideration. Thus,
in case of differential costing a comparison is made between the cost differential and income
differential between two or more situations and decisions regarding adopting a particular cause
of action is taken if it is on the whole profitable.

 Marginal Costs and Average Costs

Marginal cost refers to increase or decrease in the amount of cost on account of increase or
decrease of production by a single unit. The unit may be a single article or a batch of similar
articles.

Marginal cost is thus, the total variable cost because within the capacity of the organization, an
increase of one unit in production will cause an increase in variable cost only.

Average cost per unit is the total cost for whatever quantity is manufactured, divided by the
number of units manufactured. Marginal costs and average costs arise in a variety of economic
situation. The University administrator might be interested in the marginal cost of educating one
additional student and a Toyota executive might want to know the marginal cost of producing
one more Toyota van. A bus tour company manager might be interested in the average cost per
mile on the bus route etc.

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