Cost Concepts and Classifications

COST CONCEPTS
AND
CLASSIFICATIONS
LEARNING OBJECTIVES
• Explain the relationship between financial accounting and cost
accounting;
• Identify the different classification of costs;
• Compare flow of costs in service, trading and manufacturing
firms;
• Distinguish actual costing method from normal costing method;
• Separate the variable and fixed components of a mixed cost;
• Prepare cost of goods manufactured and sold in good form
including Income Statement and Balance Sheet of a
manufacturing concern; and
• Compare/distinguish income statement of service, trading and
manufacturing terms.
COST ACCOUNTING
• It is a discipline that focuses on techniques or methods for
determining the cost of a product and services.
• It measures and reports both financial and non-financial

information relating to the cost of acquiring or consuming
resources in an organization.
• It identifies, defines, measures, reports, and analyzes the various

elements of costs associated with producing and marketing goods
and services.
FUNCTIONS OF COST ACCOUNTING
• It focuses primarily on the determination of the cost of making
products or performing services.
• It determines the cost of products or services by direct measurement,

arbitrary assignment, and systematic or rational allocation of such
cost.
• It integrates with financial accounting by providing product costing

information for financial statements, and with management
accounting by providing quantitative, cost-based information that
managers need to perform their functions.
FINANCIAL ACCOUNTING VS COST
ACCOUNTING
COST VS EXPENSE
• Cost – represents any amount paid or incurred in acquiring goods or

services. It is presented in the statement of financial position as an asset
(example: amount paid in purchasing equipment).
• Expense – represents aby amount paid or incurred in the operation of a

business. It is necessary to generate revenue. It is presented in the income
statement (example: depreciation of equipment).
CLASSIFICATION OF COSTS
PRODUCT COST
Manufacturing Cost- sum of the inputs or resources used in the conversion of raw
materials into finished products.
Product costs include Direct Materials, Direct Labor, Factory Overhead
PERIOD COSTS
PERIOD COSTS ARE OPERATING EXPENSES THAT ARE ASSOCIATED WITH

TIME PERIODS, RATHER THAN WITH THE PRODUCTION OF GOODS AND
SERVICES. IT IS DIRECTLY CHARGED TO EXPENSE ACCOUNTS ON THE
ASSUMPTION THAT THEIR BENEFIT IS RECOGNIZED ENTIRELY IN THE
PERIOD WHEN THE COST IS INCURRED.
They are non- manufacturing costs and inventoriable costs.

They are non- manufacturing costs and inventoriable costs.
a. Marketing and Selling Costs- cost of getting and filling orders such as cost of
customer service, cost of documentation, salaries and commissions pf sales personnel.
b. Distribution costs- These are costs of warehousing, transporting, and delivering a

product or service.
c. Administrative Costs- costs associated with the general administration or

organization that cannot be reasonably assigned to either marketing or production
such as salaries and wages of administrative officers and employees.
As to functional areas of an organization:
• Manufacturing Cost – is the cost incurred in the production of the product or service.
• Direct Materials – are raw materials directly identifiable as part of the final product
• Direct Labor – are amounts paid to the factory workers who are directly engaged in
the conversion of raw materials to finished product.
• Manufacturing Overhead – are costs related to a particular cost object but cannot be
traced to that cost object in an economically feasible way.
• Non-Manufacturing Cost – is the cost incurred in administering the operation of the

business and commercializing the product or service.
As to traceability:
• Direct Cost – is the cost that can be traced to a particular unit or department.
• Indirect Cost – is the cost that is not directly traceable to a particular unit or
department.
As to controllability:
• Controllable Cost – is the cost that the manager can significantly or heavily influence
its incurrence.
• Uncontrollable Cost – is the cost that the manager cannot significantly influence its
incurrence.
As to timing of charges to revenue:
• Product Cost – is the cost assigned to goods or services until sold.

• Period Cost – is the cost matched against revenues in the same time period in
which it is incurred.
As to avoidance:
• Avoidable Cost – is the cost that can be avoided by making one choice over the
other.
• Unavoidable Cost – is the cost that cannot be changed in the future when
choosing one decision over the other.
As to decision making:
• Opportunity Cost – it is the benefit sacrificed when choosing one action over the other.
• Differential Cost – it is the amount by which the cost differs under two alternative actions.
• Relevant Cost – it is the cost incurred in one alternative but will not be incurred in another alternative.
• Marginal Cost – it is the extra cost incurred when one additional unit is produced.
• Average Cost – it is the result if the total cost to produce the product is divided by the number of units
manufactured or produced.
• Sunk Cost – it is the cost that has been paid or incurred.
• Out-of-Pocket Cost – it is the cost that requires the payment of cash or other assets in the future as a
result of its incurrence.
As to activity and its behavior:
• Fixed Costs – are costs that are constant in total within the relevant range of
activity but variable on a per unit basis.
• Variable Costs – are costs that vary in total in direct proportion to changes in the
volume of production. These are constant on a per unit basis as activity changes
within the relevant range.
• Mixed Costs – are costs that have both fixed and variable component.
SEPARATING MIXED COST
When cost is classified as mixed, it is appropriate to separate the fixed cost from the
variable cost. One of the methods used is high-low method.
Procedures:
•Select the highest and lowest levels of activity and costs (within relevant range).
•Compute the variable cost element. Variable cost per unit is computed as:
•cost at high level – cost at lowest level (within relevant range) / highest activity –
lowest activity; or
•change in total costs / change in activity level
•Compute the variable cost at the highest and lowest level of activity.
•Determine the fixed cost at each level of activity.
INVENTORY ACCOUNTS
In a manufacturing setting, there are three inventory accounts:
Raw Materials Inventory – it shows the raw materials available for use in the
manufacturing process.
Work in Process Inventory – it represents the costs of partially completed goods that
have been started but not yet completed as of a certain period.
Finished Goods Inventory – it summarizes the costs of completed goods stored in

the warehouse ready for delivery to customers.
INVENTORY SYSTEMS
Periodic Inventory System
• It keeps track of inventory balances continuously with updates made

automatically whenever a product is received or sold.
• It is best suited to businesses with high sales volume and multiple retail outlets
like grocery stores or pharmacies.
Perpetual Inventory System

• It uses an occasional physical count to measure the level of inventory and the
cost of goods sold.
• It is best suited to small businesses due to the expense of acquiring the
technology and staff to support a perpetual system or businesses selling high
value items such as car dealership or art gallery.
THE FLOW OF MANUFACTURING
COSTS
COSTS
COSTS
METHODS OF ACCUMULATING
PRODUCT COSTS
Actual Costing System
• It requires that all production overhead must be available before any cost allocation can be made to
the jobs in process.
Normal Costing System

• The manufacturing overhead is applied to the production using a predetermined overhead rate
(plant-wide or departmental).
• Predetermined overhead rate is the ratio of estimated total overhead to the estimated total of cost
driver selected.
DISPOSITION OVERHEAD VARIANCE
Under the normal costing, actual and applied overhead are usually not equal.
The two are compared at the end of the period to evaluate the appropriateness of predetermined
overhead rate used:
if actual > applied = underapplied (unfavorable)

if actual < applied = overapplied (favorable)
If the variance is insignificant, it is closed to Cost of Goods Sold:

Cost of Goods Sold xxx
Manufacturing Overhead xxx
If the variance is significant, it is closed to all accounts with overhead element:

Manufacturing Overhead xxx
Work in Process Inventory xxx
Finished Goods Inventory xxx
Cost of Goods Sold xxx
End of
COST CONCEPTS AND
CLASSIFICATIONS

Cost Concepts and Classifications

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Cost Concepts and Classifications

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COST CONCEPTS

• It measures and reports both financial and non-financial

• It identifies, defines, measures, reports, and analyzes the various

• It determines the cost of products or services by direct measurement,

• It integrates with financial accounting by providing product costing

• Cost – represents any amount paid or incurred in acquiring goods or

• Expense – represents aby amount paid or incurred in the operation of a

Product costs include Direct Materials, Direct Labor, Factory Overhead

PERIOD COSTS ARE OPERATING EXPENSES THAT ARE ASSOCIATED WITH

They are non- manufacturing costs and inventoriable costs.

They are non- manufacturing costs and inventoriable costs.

b. Distribution costs- These are costs of warehousing, transporting, and delivering a

c. Administrative Costs- costs associated with the general administration or

• Non-Manufacturing Cost – is the cost incurred in administering the operation of the

• Product Cost – is the cost assigned to goods or services until sold.

• Sunk Cost – it is the cost that has been paid or incurred.

As to activity and its behavior:

In a manufacturing setting, there are three inventory accounts:

Finished Goods Inventory – it summarizes the costs of completed goods stored in

Periodic Inventory System

• It keeps track of inventory balances continuously with updates made

Perpetual Inventory System

Normal Costing System

if actual > applied = underapplied (unfavorable)

If the variance is insignificant, it is closed to Cost of Goods Sold:

If the variance is significant, it is closed to all accounts with overhead element:

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