Introduction to Cost Accounting

This unit introduces to the learners cost accounting. It starts from the basic elements of
accountability and arrives to describe each part of cost accounting.

DEFINITION OF COST ACCOUNTING

Cost accounting is the art and science of recording, classifying, summarizing, and analyzing
costs to help management make prudent business decisions

OBJECTIVE OF COST ACCOUNTING

The main objectives of cost accounting is as follows:

1. Ascertainment of cost.

2. Cost control and cost reduction

3. Assisting management in decision-making including pricing, profit planning, budgeting

RELATIONSHIP of Financial, Management and Cost Accounting

Financial Accounting

❖ Accounting information is used for reporting to external parties, including investors and
creditors.
 ❖ Concerned primarily with financial statements for external use by those who supply
funds to the entity and other persons who may have vested interest in the financial
operations of the firm.

❖ Reports prepared to focus on the enterprise as a whole.

❖ Information may be historical, quantitative, monetary and verifiable.

❖ Information provided is usually presented in the form of financial statements, tax returns,
and other formal reports distributed to various external users and regulatory agencies of the
government like SEC, BIR.

❖ Information may also be used internally to provide a basis for financial analysis by
management.

Managerial Accounting

❖ Focuses on the needs of parties within the organization, rather than interested parties
outside the organization.

❖ Information commonly addresses individual or divisional concerns rather than those of

the enterprise as a whole.

❖ Information may be current or forecasted, quantitative or qualitative, monetary and non-

monetary and most of all timely, the data are futuristic and some of the costs are not
recorded in the accounting books of the organization.

❖ More concern on the timeliness of the information so management cannot wait until
tomorrow for information that is required for today’s decision.

Cost accounting

❖ The intersection between financial and managerial accounting.

❖ Information is needed and used by both financial and managerial accounting

❖ Provides product cost information to external parties, such as stockholders, creditors and
various regulatory boards for credit and investment decisions.
❖ Provides product cost information also to internal parties such as managers for planning
and controlling.

COST is the cash or cash equivalent value sacrificed for goods and services that are
expected to bring a current or future benefits to the organization. Costs are incurred to
produce future benefits in a profit-making firm, future benefits mean revenue. As costs are
used up in the production of revenue, 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 on cost accounting is on costs. Not expenses.

CLASSIFICATION OF COSTS

I. Costs classified as to relation to a product

A. Manufacturing costs/product cost

1. Direct Materials

2. Direct labor

3. Factory overhead

B. Non-manufacturing costs/period cost

1. Marketing or selling expense

2. General or administrative expense

II. Costs classified as to the variability

A. Variable costs

B. Fixed costs

C. Mixed costs

III. Costs classified as to relation to manufacturing departments

 A. Direct departmental charges

B. Indirect departmental charges

IV. Costs classified as to their nature as common or joint

A. Common costs

B. Joint cost

V. Costs classified as to relate to an accounting period.

A. Capital expenditures

B. Revenue expenditures

VI. Costs for planning, control, and analytical processes

A. Standard costs

B. Opportunity costs

C. Differential costs

D. Relevant costs

E. Out-of-pocket cost

F. Sunk cost

G. Controllable cost

MANUFACTURING COSTS/PRODUCT COSTS/INVENTORIABLE COSTS

Direct materials cost are those materials used that can be traced to the finished products.

Direct labor costs are the amount paid as wages to those working directly on the product.

Factory overhead costs a catch-all for manufacturing cost that cannot be classified as
direct materials and direct labor costs.
For example, if we are to produce a T-shirt, we need cloth, thread, needle, scissors, sewing
machine, dressmaker, sewing machine oil, janitor, factory/building, electricity. From here we
are to identify what are the types of costs we encounter to produce the product.

Direct Material is the cloth

Direct labor is dressmaker wage that directly makes the product. ( example: labor hours x
labor rate)

Factory overhead is the thread, needle, scissors, depreciation of sewing machine, sewing
machine oil, electricity and rent or depreciation of the factory building, wage of the janitor
that cannot be traced on the product but are needed to produce/make the
product.

Prime costs = Direct labor plus Direct materials

Conversion costs = Direct labor plus Factory overhead

Total manufacturing cost = Direct labor plus Direct materials plus Factory overhead

NON-MANUFACTURING COSTS/PERIOD COSTS

Marketing or selling expenses include all costs necessary to secure customer orders and
get the finished products or service into the hands of the customer. Examples are
advertising, shipping, sales travel, sales commissions, sales salaries, and expenses associated
with finished goods warehouses.

General or administrative expense includes all executive, organizational and clerical

expenses that cannot logically be included under either production or marketing.
COSTS CLASSIFIED AS TO VARIABILITY

Fixed costs are costs which remain constant in total, irrespective of the volume of
production.

Fixed cost may be classified into two categories, depending on the ability of management
to influence the level of these costs in the short term.

1) Committed fixed cost – a cost that represents relatively long term commitments on the
part of the management as a result of past decisions. Example – depreciation on equipment.

2.) Managed fixed cost (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.

Shown below is a graph of fixed cost. It is clearly shown that total fixed costs remain
unchanged as activity changes. When activity triples from 10 to 30 units total fixed cost
remains constant at P1,500. If the activity level is 10 units then the fixed cost per unit is
P150. If the activity level is 30 units, then the fixed cost per unit declines to P50 per unit.

Variable costs are cost which varies directly, in total, in relation to the volume of
production. Examples are: direct materials, direct labor, royalties, and commission of
salesmen.

Shown on the next page is a graph of the total variable cost. The total variable cost
increases proportionately with the activity. When activity doubles from 10 to 20 units, total
variable cost doubles from P1,000 to P2,000. However, the variable unit cost remains the
same as activity changes.

Mixed costs are cost with fixed and variable components.

Two types of a mixed cost

1. Semi-variable 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. Example, a cellular plan with a fixed rate of
P15,000 at a specified number of times of usage, however, if the user exceeds the time
allowed, then charges will be made on a per-minute basis.
2. Step costs the fixed part of step cost changes abruptly at various activity levels because
these costs are acquired in indivisible portions. Example, a Supervisor’s salary of P20,000
needed for every 10 workers, then if 15 workers are used, 2 supervisors (With a salary of
P40,000) will be needed. If 18 workers are used, still, 2 supervisors would be needed. If the
number of workers increases to 22, three supervisors will be needed.

To summed it up,
Common cost is the cost of facilities or services employed in two or more accounting
periods, operations, commodities, or services. For example, if two departments are
occupying the same building, the depreciation of the building is a common cost subject to
allocation based on the floor area occupied.

Joint cost is the costs 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 costs incurred to manufacture two or more
products up to the split-off (or where they will go separate ways).

Capital expenditures are expenditures intended to benefit more than one accounting
period and are recorded as an asset. The allocation of the cost to the different periods is
depreciation for the fixed tangible asset, amortization for intangible assets, and depletion
for wasting assets.

Revenue expenditures are expenditures that will benefit the current period only and are
recorded as an expense.
Direct departmental charges are 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 are 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 cost.

Standard costs are 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.

Opportunity costs the benefit given up when one alternative is chosen over another.
Opportunity cost is not usually recorded in the accounting system. However, the
opportunity cost should be considered when evaluating alternatives for decision-making.
For example, Eva is employed with a company that pays her a salary of P35,000 a month.
She is thinking of leaving the company and returning to school. Since returning to school
would require that she give up her P420,000 salaries. The foregone salary would be an
opportunity cost of seeking further education.

Differential costs a 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 costs) and cost decreases
(decremental costs) between alternatives. To illustrate, assume Avon Corp. Is thinking about
changing its marketing method from distribution through the retailer to distribution by
direct sale. Present cost and revenues are compared to projected cost and revenues in the
table below:

Retailer Direct sale Differential

Distribution Distribution Cost and
(Present) (Proposed) Revenues
Revenues (V) P 900,000 P 1,200,000 P 300,000
Cost of goods sold (V) 450,000 600,000 150,000
Advertising (V) 80,000 45,000 (35,000)
Commission (V) - 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

========= ========== =========

Relevant costs a future cost that changes across the alternatives. In the example above, the
relevant costs are the cost of goods sold, advertising, commissions, and warehouse
depreciation.

Out-of-pocket cost - a cost that requires the payment of money (or other assets) as a
result of their incurrence.

Sunk cost - refers to money that has already been spent and which cannot be recovered.
To illustrate the notion of a sunk cost, assume that a firm has just paid P250,000 for a
special-purpose machine. Since the cost outlay has been made, The P250,000 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 cost is considered to be a controllable cost at a particular level of

management if that level has the power to authorize the cost. For example, entertainment
expenses would be controllable by a sales manager if he or she had the power to authorize
the amount and type of entertainment for customers. On the other hand, depreciation of
warehouse facilities would not be controllable by the sales manager(Non-controllable
costs) since he or she would have no power to authorize warehouse construction.

LEARNING ASSESSMENT

Part 1
True or False

1. The controller is not an internal user.

2. Planning is a function that involves setting the goals and objectives of an entity.

3. The manager that is establishing objectives is performing a planning management

function.

4. Most internal reports are summarized rather than detailed.

5. Management accounting information pertains to sub-units of the entity and may be very
detailed.

6. Cost accounting is not important to any company.

7. Management accounting applies to all forms of business organizations.

9. The degree of timeliness is not critical in management accounting.

10. Cost accounting is the intersection between financial and management accounting.

11. Job order costing is used by companies making one-of-a-kind products.

12. Financial accounting information generally pertains to an entity as a whole and is highly
aggregated.

13. Determining the unit cost of manufacturing a product is an output of Cost accounting.

14. Management accounting information generally prepared for stockholders.

Part 2

Problem 1

Presented below is a list of costs and expenses usually incurred by Fidel Corporation,
manufacturer of furniture in its factory.

1. Metal used in manufacturing tables.

2. Insurance on factory machines.

3. Leather used in manufacturing furniture.

4. Wages paid to machine operators.

5. Depreciation of factory machinery.

6. Salaries of factory supervisors.

7. Wood used in manufacturing furniture.

8. Sand paper, volts, and nails.

9. Property taxes on factory building

10. Rent of factory building

Required: Classify the above items into the following categories: (a) direct materials, (b)
direct labor, and (c) manufacturing overhead.

Problem 2

Classify the following as to fixed, variable or mixed

1. Factory rent

2. Wages for workers paid based on units produced.

3. Equipment maintenance.

4. Cost Accountant’s salary.

5. Depreciation based on output.

6. Salary of factory supervisor.

7. Telephone (monthly).

8. Paper in the manufacture of books.

9. Wages of machine operators.

10. Commission of salesmen.

Part 3

Classify each of the following cost of Joan Company in two ways: (a) Variable Cost or Fixed
Cost; (b) Inventoriable cost or Period Cost:

(a)
(b)

Example: Direct labor Variable cost Inventoriable cost

1. Wood used in bookcases ____________ _______________

2. Machine depreciation based on machine hours____________ _______________

3. Fire insurance on factory equipment. ____________ _______________

4. Wiring used on radios. ____________ _______________

5. Indirect Materials ____________

_______________

6. Sales commissions. ____________

_______________

7. Bottles used to package liquid. ____________ _______________

8. Gasoline for a delivery truck ____________ _______________

9. Straight-line depreciation of trucks used for

delivery of sales to customers ____________ _______________

10. Machine operator’s hourly wages. ____________ _______________

Part 4

MULTIPLE CHOICE

1. Indirect material cost is a

Conversion cost Prime cost

a. No No

b. No Yes

c. Yes Yes

d. Yes No

2. Direct labor cost is a

Conversion cost Prime cost

a. No No

b. No Yes

c. Yes Yes

d. Yes No

3. Indirect labor is a

a. Prime cost c. Period cost

b. Conversion cost d. Non-manufacturing cost

4. In a job cost system, manufacturing overhead is

An indirect cost of jobs A necessary element of production

a. No Yes

b. No No

c. Yes Yes

d. Yes No
5. Prime cost and conversion cost share what common element of total cost?

a. Variable overhead c. Direct materials

b. Fixed overhead d. Direct labor

6. Which of the following is an element of prime cost

Direct materials Direct labor

a. Yes Yes

b. Yes No

c. No Yes

d. No No

7. Wages paid to factory machine operators of a manufacturing plant are an element of

Prime cost Conversion cost

a. No No

b. No Yes

c. Yes No

d. Yes Yes

8. Cost that vary inversely with changes in volume include

a. Total variable costs c. Total fixed costs.

b. Total variable costs divided by volume d. Total fixed costs divided by volume
9. When a unit of product is the cost object, factory overhead generally is:

a. A direct manufacturing cost. c. Both a and b.

b. An indirect manufacturing cost. d. None of the above.

10. Factory rent is:

a. A prime cost and an inventoriable cost.

b. A prime cost and a period cost.

c. A conversion cost and an inventoriable cost.

d. A conversion cost and a period cost.

11. Examples of factory overhead costs are:

a. Lubricants for factory machinery. c. Both a and b.

b. Depreciation of factory machinery. d. None of the above.

12. In general, cost that could usually be most reliably predicted is:

a. Variable cost per unit c. Total variable cost.

b. Fixed cost per unit d. Total fixed cost.

13. Factory supplies used would be an example of which of the following?

Prime cost Conversion cost

a. Yes Yes

b. Yes No
c. No Yes

d. No No

14. For a manufacturing company, which of the following is an example of a period rather
than a product cost?

a. Depreciation of factory equipment. c. Wages of machine operator.

b. Wages of a sales person. d. Insurance on factory equipment.

15. The variable portion of the semi variable cost of electricity for a manufacturing plant is a:

Conversion cost Period cost

a. No No

b. No Yes

c. Yes No

d. Yes Yes

16. Indirect costs are also known as:

a. Differential costs c. Opportunity costs

b. Common costs. d. Sunk costs

17. Variable cost

a. Increases on a per unit basis as the number of units produced increases.

b. is constant if expressed on a per unit basis.

c. remains the same in total as production increases.

d. is not affected by changes in activity from period to period.

18. All of the following are examples of product cost except:

a. Depreciation on the company’s retail outlets. c. Insurance on the factory equipment.

b. Salary of the plant manager. d. Rental costs of the factory facility.

19. The distinction between indirect and direct cost depends on

a. whether a cost is controllable or non-controllable.

b. whether a cost is variable or fixed.

c. whether a cost is a product or a period cost.

d. whether a cost can be conveniently and physically traced to a unit under consideration.

20. Which of the following should not be included as manufacturing overhead in the
manufacture of a wooden chair?

a. Glue in the chair.

b. The amount paid to the individual who stains the chair.

c. The workman’s compensation insurance of the supervisor who oversees production.

d. The factory utilities of the department in which production takes place.