Cost Accounting and Control

Introduction to Cost Accounting

 The main and primary objective of accounting is to provide financial information about an
economic entity to different types of users.
 Internal users:
✓ Managers for planning
✓ Controlling
✓ Decision making
 External Users:
✓ Government
✓ Those who provide funds
✓ Those who have various interest in the operations of the entity.
Cost Accounting
 Is an expanded phase of general or financial accounting which informs management
promptly with the cost of rendering a particular service, buying and selling a product,
and producing a product.
 It is the field of accounting that measures, records, and reports information about costs.
 All types of business entities - manufacturing, merchandising and service businesses -
require information systems which provide the necessary financial data.
 Because of the nature of the manufacturing process, the information systems of
manufacturing entities must be designed to accumulate detailed cost data relating to the
production process.
 Thus, it is common costs accounting systems.
 These systems should show what costs were incurred and how these costs were utilized.
 Cost accounting today is recognized as being essential to efficient cooperation of business
and industry.
 In order to appreciate the importance of an efficient cost system, it is necessary to
understand the nature of the manufacturing process.
 In many ways, the activities of a manufacturing organization are similar to those of a
merchandising business.
 Both are concerned with purchasing, storing, and selling goods; both must have efficient
management and adequate sources of capital; both may employ hundreds or thousands
of workers.
 In the manufacturing process itself, we see the distinction between the two:
✓ Merchandisers, such as SM buy items in marketable form to be resold to their
customers;
✓ Manufacturers, such as PHILACOR, must make the goods they sell.
 Once the merchandising organization has acquired and stored goods, it is ready to carry
out the marketing function.
 The purchase materials by a manufacturer, however, is only the beginning of a long, and
sometimes complex, chain of events that will eventually produce a finished article ready
for sale.
 The manufacturing process involves the conversion of raw materials into finished goods
through the application of labor and the incurrence ofvarious factory expenses.
 The manufacturer must make a major investment in physical facilities, such as factory
buildings and warehouses, and acquire many specialized types of machinery and
equipment.
 In order to carry out the manufacturing process, the manufacturer must purchase
appropriate quantities of raw materials, Supplies and parts, and build up a work force to
convert these resources into finished goods.
  Once the goods are completed and are ready for sale, the manufacturer performs
basically the same functions as the merchandiser in storing and marketing the goods.
 The methods of accounting for sales, cost of goods sold, and selling and administrative
expenses are also similar to those of the merchandising organization.
 Although cost accounting developed originally in manufacturing business to satisfy
management's need for product cost information, cost accounting information is useful
for all types of activities in all types of organizations.
 Cost accounting is essential not only for profit-seeking entities but also for not-for-profit
organizations such as governmental agencies, churches, and charities.
Comparison of Financial, Managerial, and Cost Accounting
 2 major areas of accounting:
1. Financial Accounting
2. Managerial Accounting
Financial Accounting
 Is the use of accounting information for reporting to external parties, including investors
and creditors.
 Financial accounting is primarily concerned with financial statement 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.
 The suppliers of funds include stockholders (the owners of the corporation) partners (the
owners of the partnership) and sole proprietors.
 Creditors, who provide debts are also interested on the financial statements of the entity.
 The financial statements are the output from an accounting system.
 The reports prepared under financial accounting focus on the enterprise as a whole.
 Financial accounting is based on historical transaction data.
 The information may be historical, quantitative, monetary and verifiable.
 The data are historical and are supported by documents (evidence).
 The information provided by financial accounting is usually presented in the form of
financial statements, tax returns, and other formal reports distributed to various external
users.
 The same information may also be used internally to provide a basis for financial analysis
by management.
 Financial accounting is required for many firms organized as corporations because of the
requirements of the Securities and Exchange Commission.
 The Bureau of Internal Revenue also requires financial accounting information for
compliance with the country's tax laws.
 Information based on accounting data is required for all firms without regard to their size.
Managerial Accounting
 Focuses on the needs of parties within the organization, rather than interested parties
outside the organization.
 Managerial accounting information commonly addresses individual or divisional concerns
rather than those of the enterprise as a whole.
 The information may be current or forecasted, quantitative or qualitative, monetary or
non-monetary and most of all timely the data are futuristic and some of the costs are not
recorded on the accounting books of the organization.
 Managerial accounting is not separate and distinct from financial accounting.
 Financial accounting data are used in the managerial accounting system.
 Management decisions made today will affect the financial statement of future periods.
 There is no requirement or legislation that mandates the format or use of managerial
accounting.
 Managerial accounting methods are tools that are available for use to management.
  Financial accounting attempts to present some degree of precision in reporting historical
information while at the same time emphasizing verifiability and freedom from bias in the
information, relevance to the general user and some degree of timeliness in reporting
which is not as critical in managerial accounting.
 The measuring based in managerial accounting does not necessarily have to e restricted
to pesos.
 Various bases may be appropriate to report managerial information.
 Example:
✓ An economic measure such as pesos
✓ A physical measure such as: pounds, gallons, tins or units.
✓ A relationship measure such as ratios.
Cost Accounting
 Is the intersection between financial and managerial accounting.
 Cost accounting information is needed and used by both financial and managerial
accounting.
 Cost accounting provides product cost information to external parties, such as
stockholders, creditors and various regulatory boards for credit and investment decisions.
 Cost accounting provides product cost information also to internal parties such as
managers for planning and controlling.
Relationship of Financial, Management, and Cost Accounting

Merchandising vs. Manufacturing Operations

 Much of our accounting education has centered on the merchandising organization.
 Thus, it is important here to explain the difference in accounting for manufacturing firms
and merchandising firms.
 Many types of businesses gather information on costs, but doing so is especially
important in manufacturing.
Merchandising
 Merchandising company normally buys a product that is ready for resale when it is
received.
 Nothing needs to be done to the product to make it salable except possibly to prepare a
special package or display.
Figure 1-1
Total beginning merchandise inventory plus purchases is the basis for computing both the cost of
goods sold and ending merchandise inventory (MI) balances.
 Cost assigned to unsold items make up the ending inventory balance.
 The difference between the cost of goods available for sale and the ending inventory
amount is the cost of goods sold during the period.
Example:
Beginning merchandise inventory 5 000
Plus: Total Purchases 24 000
Cost of goods available for sale 29 000
Less: Ending merchandise inventory 6 500
Cost of goods sold 22 500

 Figure 1-1 show how easy it is to compute the cost of goods sold for a merchandising
company.
 The only expenditure occurs when salable goods are purchased.
 Any item unsold at year end make up the ending inventory balance.
 Cost of goods sold is computed by subtracting the ending Inventory (MI end) balance
from the total of the beginning inventory balance and purchases during the period.
Figure 1-1. Cost of Goods sold for a Merchandising Company
Figure 1-2. Cost of Goods Sold for a Manufacturing Company

Note:
• Computing the cost of goods sold for a manufacturing company is more complex.
• As shown in figure 1-2 instead of one inventory account, a manufacturer maintains 3
inventory accounts:
✓ Materials Inventory
✓ Work in Process Inventory
✓ Finished Goods Inventory
• Purchased materials unused during the production process make up the ending Materials
Inventory balance.
• The cost of materials used plus the costs of labor services and factory overhead are
transferred to the Work in Process Inventory account when the materials, labor services,
and overhead items are used in the production process.
• Factory Overhead includes such items as:
✓ Indirect materials
✓ Indirect labor
✓ Utility costs
✓ Depreciation of factory machinery
✓ Depreciation of factory building
✓ Supplies
 • 3 types of cost mentioned are often called:
✓ Direct materials (DM)
✓ Direct labor (DL)
✓ Factory overhead (FO)
• These costs are accumulated in the Work in Process Inventory (WP Invty.) account
during an accounting period.
• When a batch or order is completed, all manufacturing costs assigned to the completed
units are moved to the Finished Goods Inventory account.
• Costs remaining in Work in Process Inventory account belong to partly completed units.
• These costs make up the ending balance in the Work in Process Inventory account.
• The Finished Goods Inventory (FG Inventory) account is set up in the same way as the
Merchandise Inventory account under Merchandising.
• Costs of completed goods are entered into the Finished Goods Inventory account.
• Then costs attached to unsold items at year end make up the ending balance in the
Finished Goods Inventory account.
• All costs related to units sold are transferred to the Cost of Goods Sold account and
reported on the income statement.
Uses of Cost Accounting Data
 The information produced by a cost accounting system provides a basis or determining
product cost and aids management in planning and controlling operations.
Determining Product Costs
 Cost accounting procedures help management in gathering the data needed to
determine product costs and thus generate meaningful financial statements and other
reports.
 Cost procedures must be designed to permit the computation of unit costs as well as
total product costs.
 For example, if a manufacturer spent P10 000 for labor in a certain month, the
information is insignificant; but if this labor produced 5 000 finished units, the fact that
the cost of labor was P2 per unit is significant, because this figure can be compared to the
unit labor cost of other periods and the trends analyzed.
 Unit cost information is also useful in making a variety of important marketing decisions.
1. Determining the selling price of a product
• A knowledge of the cost of manufacturing a unit or product helps in setting the
selling price, which should be high enough to cover the cost of production, pay a
portion of marketing and administrative expenses and provide a profit.
• It will be difficult to set the selling price without knowing the costs incurred in the
manufacture of a product and cost incurred in rendering a service.
2. Meeting competition
• If a competitor is selling the product at a low price, detailed information regarding
unit costs can be used to determine the action to be taken by the company.
• The company would know if selling price must be reduced, or manufacturing costs
must be reduced, or the product must be eliminated.
3. Bidding on Contracts
• Many manufacturing firms must submit competitive bids in order to be awarded
manufacturing contracts by the government or private firms.
• An analysis of the unit costs relating to the manufacture of a particular product is
of great importance in determining the bid price to be submitted.
• The bid price must be able to cover costs to be incurred and at the same provide
profit for the company.
• It must not be set so high so as to be able to compete with other bidders.
 4. Anlayzing Profitability
• Unit cost information enables management to determine the amount of profit
that each product earns and possibly eliminate those that are least profitable,
thereby concentrating efforts on those items that are most profitable.
Costs
 Are said to be used for managerial accounting purposes when costs are used inside the
organization by managers to evaluate the performance of operations or personnel, or as
a basis for decision making.
 When costs are used by outsiders, such as stockholders or creditors, to evaluate the
performance of top management and make decisions about the organization, we say
costs are used for financial accounting purposes.
Planning and Control
 One of the most important functions of cost accounting is the development of
information which can be used by management in planning and controlling operations.
Planning
 Is the process of establishing objectives or goals for the firm and determining the means
by which the firm will attain them.
 Planning is essential to good management because it provides a means of coordinating all
of the operations of firm.
 Cost accounting helps in the development of plans by providing historical costs that serve
as basis for projecting data for planning.
 Management can analyze trends and relationships among such data as an aid estimating
future costs and operating results and in making decisions regarding the acquisition of
additional facilities, changes in marketing strategies, and obtaining additional capital.
Planning can be divided into 3 components:
1. Strategic Planning
• Concerned with setting long range goals and objectives to determine the overall
direction of the company.
2. Tactical Planning
• Concerns with plans for a shorter range (or time period) and emphasizes plans to
achieve the strategic goals.
3. Operations Planning
• Relates to the day to day implementation of tactical plans.
• It emphasizes the coordination of the major factors of production (materials,
labor and facilities).
Control
 Is the process of monitoring the company's operations and determining whether the
objectives identified in the planning process are being accomplished.
Recent Developments in Cost Accounting
• Cost accounting is experiencing dramatic changes.
• Manual bookkeeping has been reduced because of the use of computers.
• Changes in production methods have made traditional applications of cost accounting
obsolete in some cases.
• Increasing emphasis on cost control is seen now in hospitals, in industries facing stiff
foreign competition and in any organizations that have traditionally not focused on cost
control.
• The traditional role of cost accounting is to record full product cost data for external
reporting.
• However, the use of accounting data for decision making and performance evaluation has
gained importance in recent years.
Cost Accounting and Other Fields of Study
 The recording of the costs of a product or a service is part of financial accounting.
 The use of cost for valuation of inventory and cost of goods sold for external reporting is
also financial accounting.
 The use of cost data in choosing between 2 or more alternatives is part of managerial
accounting.
 Differential cost analysis is considered by others as a form of applied microeconomics.
 Cost accounting provides data for use in decision models for finance, operations
management, and marketing.
 Cost accounting is also related to motivation and behavior because it is used in planning
and performance evaluation.
 Finally, tools from statistics, mathematics, and computer sciences are used to perform
cost analysis.
2 Basic Product-Costing Systems
1. Job order costing
• A system for allocating costs to groups of unique product.
• It is applicable to the production of customer specified products such as the
manufacture of special machines.
• Each job becomes a cost center for which Costs are accumulated.
• A subsidiary record (job cost sheet) is needed to keep track of all unfinished jobs
(work in process) and finished jobs (finished goods).
2. Process costing
• A system applicable to a continuous process of production of the same or similar
goods (i.e. oil refining and chemical production.
• Since there is no need to determine the costs of different groups of products
because the product is uniform, each processing department becomes a cost
center.
Job Order vs. Process Costing
 Job order costing and process costing are the two traditional basis approaches to product
cost accounting systems.
 Actual cost accounting systems may differ widely.
 However, all are based on one of these two product costing concepts.
 Once the type of system is selected, it is then adjusted to fit a particular industry,
company, or operating department.
 The objective of the 2 systems is the same.
 They both provide product unit cost information for pricing, cost control, inventory
valuation, and income statement preparation.
 End-of-period values for the Cost of Goods Sold, Work in Process Inventory, and Finished
Goods Inventory accounts are computed using product unit cost data.
Characteristics of Job Order Costing
 Job order cost accounting system is a product costing system used by companies making
one-of-a-kind or special-order products.
 In such a system, direct materials, direct labor, and factory overhead costs are assigned
to specific job orders or batches of production.
 In computing unit costs, the total manufacturing costs for each job order are divided by
the number of good units produced for that order.
 Industries that use a job order cost accounting system include those that make ships,
airplanes, large machines, and special orders.
 Job order costing may also be used when producing a set quantity of a product for
inventory replenishment, such as a production run of 500 identical lawn mowers.
  Procedures similar to those used in job-order costing are used in many service industry
firms, even if these firms have no work in process or finished goods inventories.
 In a public accounting firms, for example, costs are assigned to audit engagements.
 For consulting and architectural firms, cost are assigned to contracts, while for
universities it maybe for every research project
The primary characteristics of a job order cost system are as follows:
1. It collects all manufacturing costs and assigns them to specific job or batches of product.
2. It measure costs for each completed job, rather than for set time periods.
3. It uses just one Work in Process Inventory Control account in the general ledger. This
account is supported by a subsidiary ledger of job order cost cards or sheets for each job
in process at any point of time.
Characteristics of Process Costing
 A process cost accounting system is a product costing system used by companies that
make a large number similar products or maintain a continuous production flow.
 In these cases, it is more economical to account for product-related costs for a period of
time (a week or a month) than to try assign them to specific products or job orders.
 Unit costs are computed by dividing total manufacturing costs assigned to a particular
department or work center during a period by equivalent unit of production.
 If a product is routed through 4 departments, then 4 unit cost amounts are added to find
the product's total unit cost.
 Companies producing :
✓ Paint
✓ Oil and gas
✓ Automobiles
✓ Bricks
✓ Soft drinks
 Use some form of a process costing system
The main characteristics of a process cost accounting system are as follows:
1. Manufacturing costs are grouped by department or work center, with little concern for
specific job orders.
2. It emphasizes a weekly or monthly time period rather than time taken to complete a
specific order.
3. It uses several Works in Process Inventory accounts - one for each department or work
center in the manufacturing process.

 Many manufacturing firms have production systems which are not suited for strictly job-
order costing or process costing, but instead require a costing system which incorporates
ideas from both.
 This blending of idea is known as hybrid costing.

 The costing system an organization selects will mainly depend on its underlying
production system.
 Operating costing is a hybrid costing system often used in repetitive manufacturing
where finished products have common, as well as distinguishing characteristics.
 For example, in the manufacture of clothing, basic suits can be assembled in one
operation.
  These suits can then move on to the next operation and have a deluxe lining added.
 Based on the variations, the products and the related costs are identified by batches or
by production runs.
 A television assembly plant, which produces a basic chassis and component system, but
which varies options such as remote control and cabinetry would be a logical user of
operation costing.
 Some companies process large orders of identical units as a group through the same
production sequence.
 Each of these orders is called a batch.
 In batch production, costs are allocated to each batch.
 Whenever a change in the production line is required to continue production, a new
batch is created.
 A furniture manufacturer may produce a batch of chairs, then a batch of tables, then a
batch of drawers, and so forth.
 Generally, job costing concepts are used to account for batch production and each batch
is treated as a job for costing purposes.
Major Differences Between Process 7 Job Order Costing
Process Costing
1. Homogenous unit pass through a series of similar process.
2. Costs are accumulated by processing department.
3. Unit costs are computed by dividing the individual department's costs by the equivalent
production.
4. The cost of production report provides the detail for the Work in Process account for
each department.
Job Order Costing
1. Unique jobs are worked on during a time period.
2. Costs are accumulated by individual job.
3. Unit costs are determined by dividing the total costs on the job sheet by the number of
unit on the job.
4. The job cost sheet provides the details for the work in process account.
Note:
• In job costing, costs are accumulated for each job or batch produced.
• In process costing, costs are accumulated by department for an accounting period (for
example, a month).
• Process costing has less detailed recordkeeping, hence, if a company was choosing
between job and process costing, it would generally find that recordkeeping costs are
lower under process costing.
• Process costing does not provide as much information as job costing because records of
the cost of each unit produced are not kept using process costing.
• The choice of process versus job costing systems involves a comparison of the costs and
benefits of each system.
• As a general rule job systems are usually more costly than process systems.
• So if managers and accountants must decide whether to use job costing process costing,
recordkeeping costs must be compared with additional benefits that will be derived from
knowing the actual cost of each unit.
• If recordkeeping costs were equal under job and process systems, for the units in a
product line, then the job costing systems are better because they provide all of the data
that process systems do.
Costs - Concepts and Classifications
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.
 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 without 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 be involved in service-type
activities.
 An understanding of the cost structure of a manufacturing company therefore provides a
broad, general understanding of costing that can be very helpful in understanding the
cost structures of other types of organizations.
 Cost is the cash or cash equivalent value sacrificed for goods and services that are
expected to bring a current or future benefit to the organization.
 We say cash equivalent because non-cash assets can be exchanged for the desired goods
or services.
 For example, it may be possible to exchange land for some needed 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
1. Costs classified as to relation to a product
a. Manufacturing costs/product costs
i. Direct materials
ii. Direct labor
iii. Factory overhead
b. Non-manufacturing costs/period costs
i. Marketing or selling expense
ii. General or administrative expense
2. Costs classified as to variability
a. Variable costs
b. Fixed costs
c. Mixed costs
3. Costs classified as to relation to manufacturing departments
a. Direct departmental charges
b. Indirect departmental charges
4. Cost classified to their nature as common or joint
a. Common costs
b. Joint costs
 5. Costs classified as to relation to an accounting period
a. Capital expenditures
b. Revenue expenditures
6. Costs for planning, control, and analytical processes
a. Standard costs
b. Opportunity costs
c. Differentia cost
d. Relevant costs
e. Out-of-pocket cost
f. Sunk cost
g. Controllable cost
Manufacturing Costs/Product Costs/Inventoriable Costs
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 manufacture products are made from basic direct materials.
 The basic material may be iron ore for steel, sheet for automobiles, flour for bread wood
tables and chairs. These examples shoe 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 run out of materials, the
manufacturing process will be forced to shut down.
 Shutting down production results in o 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 essential.
 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.
 Direct materials are materials that become part of a finished product can be conveniently
and economically traced to specific product units.
 The cost of these materials are direct costs.
 In some cases, however, even though a material becomes part of a finished product, the
expenses of actually tracing the cost of a specific 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 specific products are accounted for as indirect materials.
 Indirect materials costs are part of factory overhead costs.
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 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
canbe 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 factory overhead costs.
 Payroll related costs, such as payroll taxes, group insurance, part of direct labor costs, but
are usually included as factory overhead.
 Direct labor + direct materials = prime costs
 Direct labor + factory overhead = conversion costs
 Prime costs and conversion costs may be diagrammed as shown on the next page.
 Total manufacturing cost = direct materials + direct labor + factory overhead

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
▪ Small tools
✓ Indirect labor costs:
▪ Lift-truck driver's wages
▪ Maintenance and inspection labor
▪ Engineering labor
▪ Machine helpers
▪ Supervisors
 ✓ Other indirect factory costs:
▪ Building maintenance
▪ Machinery and tool maintenance
▪ Property taxes
▪ Property insurance
▪ Pension costs
▪ Depreciation on plant and equipment
▪ Rent expense
▪ Utility expense
Non-manufacturing Costs/Period Costs
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.
Administrative or General Expenses
 Include all executive, organizational, and clerical expenses that cannot logically be
included under either production or marketing.
 Examples of such expenses include executive compensation, general accounting,
secretarial, public relations, 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 2 categories, depending on the ability of management to
influence the levels of these costs in the short-term.
1. Committed fixed costs
• Costs that represent relatively long term commitments on the part of
management as a result of a past decision.
✓ Depreciation on equipment
 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.
✓ Advertising
✓ Research and development
✓ Costs of training of employees
Note:
• Shown below is a graph of fixed cost.
• It is clearly shown that the total fixed cost remains unchanged as activity changes.
• When activity triple, from 10 to 30 units, total fixed cost remains constant at P1 500.
• If activity level is only 1 unit, then the 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.

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 increase by 20 percent also.
 Cost per unit remains constant as volume changes within a relevant range.
✓ Direct materials
✓ Direct labor
✓ Royalties
✓ Commission of salesman
Note:
• 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 variable cost per unit remains the same as activity changes.
• The variable cost associated with each unit of activity is P100, whether it is the first unit,
the fourth, or the tenth.
• As activity changes, total variable cost increases or decreases proportionately with the
activity change, but unit variable cost remains the same.
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 cost 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 minimum is an example of such a semi-variable cost.
 The cost charged for using a cell phone under a plan is also an example of a semi-variable
cost.
 The cost of the 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.
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.

Note:
• The supervisor's salary is an example of step cost.
• Assume that one supervisor with a salary of P30 000 is needed for every 10 workers, then
if 15 workers are used, 2 supervisors (with salaries of P60 000) will be needed.
• If 18 workers are used, still 2 supervisors would be needed.
• If the number of workers increases to 22, 3 supervisors would be needed.
Reminder:
• Ideally, 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 being separated
into their fixed and variable components.
• One of the most important steps in estimating the variable and fixed components of a
mixed cost is to examine the cause and effect relationship between activities that affect
costs.
• There are different methods of separating mixed costs into fixed and variable
components:
1. Scattergraph
2. High-low point
3. Method of least square
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 42 715
October 47 726
November 43 700
December 32 630
 Direct labor hrs. Cost
Highest month (Oct.) 47 726
Lowest month (Feb.) 24 565
Difference 23 161

Variable rate per labor hour = P 161/23 hours = P7/direct labor hour
Fixed cost can be computed from either the high or low data
High Low
Total cost of electricity P726 565
Less: variable proportion
(P7 x 47) 329
P7 x 24) 168
Monthly fixed cost P397 397
Note:
• The formula for projecting the total monthly cost of electricity based on these data would
be P397 + 7 x by the direct - labor hours expected to be worked during the period (Y = FC
+ VC or FC + VX) where:
 Y = total cost
 V = variable cost per unit
 X = activity level
 VC = total variable cost
 FC = fixed cost
Method of Least Square
 The 3 formulas to be used in least-square method are:

Formula using high-low method

Y = a + bx
= 397 + 7x
Formula using least square method
Y = a + bx
= 419 + 6.77x
In most cases the amounts derived using high/low point and method of least square are not the
same.
Using the same data as in the high-low method the following have been computed:
X Y XY X2
28 625 17 500 784
24 565 13 560 576
30 630 18 900 900
33 640 21 120 1 089
38 685 26 030 1 444
34 640 21 760 1 156
35 655 22 925 1 225
40 700 28 000 1 600
42 715 30 030 1 764
47 726 34 122 2 209
43 700 30 100 1 849
32 630 20 160 1 024
426 7 911 284 207 15 620

Common cost vs. Joint Cost

Common Cost
• Costs pf facilities or services employed in two or more accounting periods, operations,
commodities, or services.
• Just like indirect costs, these costs are subject to allocation.
○ If two departments are occupying the same building, the depreciation of the
building is a common cost subject to allocation based on floor area occupied.
Joint cost
 Costs of materials, labor, and overhead incurred in the manufacture of two or more
products at the same time.
 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.
✓ Direct materials
✓ Direct labor
✓ Factory overhead cost incurred to manufacture 2 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 benefitted 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.
Opportunity Cost
 The benefit given up when one alternative is chosen over another.
 Opportunity costs are not usually recorded in the accounting system.
 However, opportunity costs should be considered when evaluating alternatives for
decision-making.
 If an asset 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 P1 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 lost 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 called
marginal cost.
 Differential costs can be either fixed or variable.

Note:
• Assume that Avon Corp. is thinking about changing its marketing method from
distribution through retailers to distribution by direct sale.
• Present costs and revenues are compared to projected costs and revenues in the table on
the next page.
• The differential revenue is P300 000 and the differential costs total P185 000, leaving a
positive differential net income of P115 00 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
• Future decision, they are not differential costs, and therefore they should be used in
analyzing future courses of action.
• 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 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 entertainment 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 negotiated, and thus management can
exercise control over the long run.

 Work in process consists of goods that are started but not completed.
 Finished goods are goods that are complete and ready for sale.
  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.
 Service organizations are different from manufacturing and merchandising because they
have no inventory of goods for sale.
 Costs are charged to responsibility centers for performance evaluation.
 In a public accounting firm, for example, costs are charged to the audit department, the
tax department, and so forth.
 Costs are also charged to jobs.
 The assignment of costs facilitates performance evaluation.
 The manager of each department is held responsible for the costs of the department, the
manager of each job is held responsible for the cost of that job.
 Of the three kinds of operations, manufacturers require the most complex and
comprehensive cost accounting system.
 All three uses cost information for decision making and performance evaluation.
 But in addition, manufacturers need product costing for inventory evaluation 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 = variable cost per unit x total output
2. Total cost = total variable costtotal fixed cost
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 lower point)